In the early 1990s, Mexico enjoyed a boom with the implementation of NAFTA. This led to a large reduction in the risk premium on capital and the resulting surge in investment caused a large shock to aggregate demand. The commitment to the fixed exchange rate led to an inability to choke off this boom by monetary tightness; the result was rising costs and prices, which, most critically, reduced exports and promoted imports, ultimately lowering aggregate demand and thus output. At the same time, the investment boom led to a potential expansion in supply capacity, which would work against the tendency for rising costs and prices, but only gradually.

In Discussion Paper No. 1241, Gregor Irwin and Research Fellow David Vines analyse the events leading to the devaluation of the Mexican peso last year, using a simple two-period model. They view the problem as a race between a foreign investment led demand boom and the potential expansion in supply which might follow. In their two-period model, the approach is to solve for the range of realizations for the state variable – which determines the extent of the supply expansion in the second period – over which the government is willing to maintain the fixed exchange rate regime. They then develop the basic model and focus on how unanticipated exogenous factors can lead to the imposition of an external financing constraint, with the reversal in capital flow during the second period. Their analysis suggests that a government, in the first stages of an exchange rate-based reform, should attempt to dampen consumption expenditure so as to `make way' for non-inflationary investment, thus reducing the competitiveness problem in the second period. They also suggest that it would be beneficial for the government to promote direct investment rather than portfolio investment: the former is likely to be more stable, making the economy less vulnerable to a reversal in capital flow. One last message may be to avoid exchange rate-based stabilization altogether: it may be better to float the exchange rate and then to base macroeconomic discipline around a tight regime for monetary aggregates (or an explicit inflation target).

The Macroeconomics of the Mexican Crisis: A Simple Two-period Model
Gregor Irwin and David Vines

Discussion Paper No. 1241, September 1995 (IM)