In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought about by a complicated sequence of events, but in this question we focus only on the dynamics of the last part of the crisis. Running low on dollar reserves in December of 1994, the Mexican central bank devalued the peso. However, unlike in our discussions in class, this devaluation was not credible – there was a spike in the risk premium investors demanded to lend to Mexico. The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg.

QUESTION

There are two options for the take home question. Each student must answer one of them. No more than one submission will be graded.

Directions: Students may work together to answer these questions but must submit their own written responses. Any two or more identical submissions will all receive a grade of zero. Answers may be handwritten or typed, but they must be submitted in a single PDF document no more than two pages in length. Submissions with more than one document or exceeding two pages will receive a grade of zero. All data obtained must be included in submissions so I can verify it. Answers without data attached receive zero credit. ________________________________________________________________________________ Question 1

In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought about by a complicated sequence of events, but in this question we focus only on the dynamics of the last part of the crisis. Running low on dollar reserves in December of 1994, the Mexican central bank devalued the peso. However, unlike in our discussions in class, this devaluation was not credible – there was a spike in the risk premium investors demanded to lend to Mexico. The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg.

(1)Using the model of contingent commitment in Chapter 9, show how a simultaneous devaluation and rise in the risk premium could lead to a scenario such as the one described above.

(2)Prior to breaking the peg, the Mexican central bank issued dollar denominated debt, which it used to buy Mexican pesos. What would you expect the impact of this type of transaction to be on M, R, B for the central bank’s balance sheet? To the backing ratio?

(3)Obtaining current data on at least two different variables, make the best argument you can for why Mexico should unilaterally peg to the US dollar again.

Question 2

Oil is an international commodity, whose price Canada takes as given. Starting around mid-2013 crude oil prices fell fairly quickly, stabilizing in mid-2015. Around the same period of time, the Canadian dollar depreciated relative to the US dollar.

(1)Use the IS-LM-FX model to explain why a decline in oil prices might lead to a depreciation of the Canadian currency.

(2)As a Central Banker what would you do to counteract this impact? Using your answer from part (1), what should happen to interest rates after the decline in oil prices? Obtain historical data on the Bank of Canada’s benchmark interest rate. Does the bank’s action appear consistent with your own recommendation?

(3)Oil prices have currently plummeted due to a price war between Saudi Arabia and Russia. Obtain recent data on the CAD/US exchange rate and compare it to your IS-LM-FX predictions from part (1). Has it behaved in the way that you would expect? Why or why not? Of the models we have studied, is IS-LM-FX the right model to use to think about this question? Why or why not? If not, what is a better theory we have studied?

ANSWER