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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