3. (UIP) What is a peso problem? In the case of fixed exchange rates, explain how peso problems can account for persistent interest rate differentials.

Study the U.S.–Britain short-term

(end-of-month) nominal interest rate differentials shown below for the year 1896 (from NBER series 13034). Both countries were on the gold standard at a fixed exchange rate of

$4.86 throughout this year. Did the United States have a peso problem? When did it become really big? When did it go away? (Extra Credit: Do some research on the Web and discover the political reasons for the timing of this peso problem.)

Jan 1896 3.84%

Feb 1896 2.94%

Mar 1896 2.76%

Apr 1896 2.40%

May 1896 1.63%

Jun 1896 1.20%

Jul 1896 1.43%

Aug 1896 3.77%

Sep 1896 3.70%

Oct 1896 8.51%

Nov 1896 2.60%

Dec 1896 −1.39%