Tequillan crisis as the example on contracdicting policy

Posted by: admin 1 year, 3 months ago

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The Mexican crisis of 1994, often called the "Tequila Crisis," was a severe financial crisis with significant economic and political implications. At its core, this crisis was triggered by a combination of economic factors and government policies, including the inconsistency between two key policies:

1. Fixed Exchange Rates: The Mexican government, led by President Carlos Salinas de Gortari, had maintained a fixed exchange rate between the Mexican peso (MXN) and the U.S. dollar (USD). This policy meant that the central bank of Mexico, Banco de México, was committed to keeping the peso's value stable relative to the dollar. This was done to promote trade and attract foreign investment.

2. Monetizing Budget Deficit: On the other hand, the Mexican government was also running budget deficits, which means they were spending more money than they were collecting in revenue. They effectively printed more pesos to finance their spending to cover these deficits. This practice is often referred to as "monetizing the budget deficit." It can lead to inflation and erode the value of the currency.

Now, let's break down why these policies were inconsistent and how this inconsistency contributed to the crisis:

• Fixed Exchange Rates vs. Monetary Policy: When a country maintains a fixed exchange rate, it essentially gives up control over its monetary policy, including interest rates and money supply. The central bank had to buy and sell pesos in the foreign exchange market to keep the peso pegged to the dollar. This required a significant reserve of dollars. However, when the government monetized its budget deficit (printing more pesos), it increased the money supply. This, in turn, put pressure on the peso's value because a larger supply of pesos could lead to depreciation.

• Investor Confidence: Foreign and domestic investors were attracted to Mexico due to the stable exchange rate policy. However, investor confidence began to wane as the peso came under pressure due to the budget deficit and increasing money supply. They worried that the government might not be able to maintain the fixed exchange rate.

• Sudden Currency Devaluation: Eventually, the Mexican government faced a situation where it was becoming increasingly expensive to defend the peso's fixed rate. When it became clear that they couldn't sustain the peg any longer, they had to devalue the peso. This led to a sharp depreciation of the peso against the dollar.

The sudden devaluation of the peso, combined with investor panic, triggered a severe financial crisis in Mexico. Foreign investors pulled their money out of the country, and the Mexican economy faced a severe recession. The crisis had ripple effects throughout the global financial system, revealing the vulnerabilities of countries with fixed exchange rate regimes and high budget deficits.

In summary, the Mexican crisis of 1994 resulted from the inconsistency between the Mexican government's policies of maintaining a fixed exchange rate and monetizing its budget deficit. These conflicting policies eroded investor confidence and eventually led to a sharp devaluation of the peso, causing a severe financial crisis.

If the explanation is still hard to understand, then refer to this easy analogy

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