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Abstract:
Exchange-rate based stabilizations, while useful in accelerating the
disinflation process, typically lead to overvalued exchange rates and large
current account deficits. These factors, in turn, make it difficult to sustain
exchange rate pegs, placing heaving demands upon monetary policy to sustain
exchange-rate based programs in their later phases. This paper evaluates the
extent to which Mexican monetary policy in 1994 may have loosened, or not
tightened sufficiently, in the lead up to the devaluation of the peso that
December. Using econometric models of the demand for money, we find evidence
that the high growth of the monetary base in 1994 reflected strong positive
shocks to the demand for money, not to its supply. Next, we estimate a
monetary policy reaction function for Mexico. Based on this estimate, we argue
that interest rates rose only moderately less in 1994, in response to downward
pressure on the peso and on international reserves, than was predicted by the
authorities' reaction function. This result is qualified somewhat by our
finding that if interest rates are modeled as reacting to reserves net of
Tesobonos, rather than gross reserves, the measured deviation of actual from
predicted interest rates would have been much greater. However, the relative
complacency with which both the authorities and the market viewed the build-up
in Tesobonos, at least until late in 1994, suggests that the reaction function
based on net reserves probably does not capture "normal" monetary policy
behavior. Our findings suggest that in order to have maintained the peg, the
authorities would have needed to intensify their response to exchange market
developments--that is, to alter their reaction function--at a time when
concerns over the health of the banking sector, and of the economy more
generally, would have pointed to a relaxation of monetary policy. Insofar as
such tightenings of monetary reaction functions are difficult to achieve,
Mexico's experience suggests that policymakers relying on the exchange rate as
a nominal anchor probably should be prepared either to abandon that anchor or
tighten monetary policy well before speculative pressures intensify.
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