Question 1

In 1994 the Mexican government abandoned their crawling peg to the US dollar. This was brought about by a complicated sequence of events, but in this question we focus only on the dynamics of the last part of the crisis. Running low on dollar reserves in December of 1994, the Mexican central bank devalued the peso. However, unlike in our discussions in class, this devaluation was not credible - there was a spike in the risk premium investors demanded to lend to Mexico. The resulting increase in interest rates and contracting output ultimately led the government to abandon the peg.

(1) Using the model of contingent commitment, show how a simultaneous devaluation and rise in the risk premium could lead to a scenario such as the one described above.

(2) Prior to breaking the peg, the Mexican central bank issued dollar denominated debt, which it used to buy Mexican pesos. What would you expect the impact of this type of transaction to be on M, R, B for the central bank's balance sheet? To the backing ratio?

(3) Obtaining current data on at least two different variables, make the best argument you can for why Mexico should unilaterally peg to the US dollar again.

my prof said there is no correct answer, it depends on how you answer and the arguments you give, need help, any insight would be good