Exam 9: Foreign Exchange Rate Determination

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Under a currency board,the central bank may increase the money supply in the banking system only with increases in its holdings of hard currency reserves.By removing the ability of government to expand the rate of growth of the money supply,Argentina believed it was eliminating the source of inflation that had devastated its standard of living.It was both a recipe for conservative and prudent financial management,and a decision to eliminate the power of politicians,elected and unelected,to exercise judgment both good and bad.It was an automatic and unbendable rule.
This "cure" was a restrictive monetary policy that slowed economic growth.The country's unemployment rate rose to double-digit levels in 1994 and stayed there.The real GDP growth rate settled into recession in late 1998,and the economy continued to shrink through 2000.Argentine banks allowed depositors to hold their money in either pesos or dollars.This was intended to provide a market-based discipline to the banking and political systems,and to demonstrate the government's unwavering commitment to maintaining the peso's value parity with the dollar.Although intended to build confidence in the system,in the end it proved disastrous to the Argentine banking system.The 1998 recession proved to be unending.Three-and-a-half years later,Argentina was still in recession.By 2001,crisis conditions had revealed three very important underlying problems with Argentina's economy: 1)The Argentine peso was overvalued; 2)The currency board regime had eliminated monetary policy alternatives for macroeconomic policy; and 3)The Argentine government budget deficit was out of control.Inflation had not been eliminated,and the world's markets were watching.
As the unemployment rate grew higher,as poverty and social unrest grew government was faced with pressure to close the economic and social gaps.Government spending continued to increase,but tax receipts did not.Argentina turned to the international markets to aid in the financing of its government's deficit spending.The total foreign debt of the country began rising dramatically.As economic conditions continued to deteriorate,banks suffered increasing runs.The government,fearing that the increasing financial drain on banks would cause their collapse,closed the banks.
On Sunday,January 6,2002 the peso was devalued from 1.00 Argentine peso per U.S.dollar to 1.40.But the economic pain continued.On February 3,2002,the Argentine government announced that the peso would be floated and the government would no longer attempt to fix or manage its value to any specific level,allowing the market to find or set the exchange rate.