The Role of the Exchange Rate Regime in Contributing to the 2001 Essay

The Role of the Exchange Rate Regime in Contributing to the 2001 Crisis in Argentina - Essay Example Argentina underwent structural changes in the 1990’s. In the late 1980’s, Argentina suffered high levels of inflation. Thus, in the 1990’s, the administration of president Menem implemented several reforms to overcome the country’s macroeconomic instability through the Convertibility Plan (Rodriguez – Boetsch 2005, p.302). Inflation dropped to single digits, whereas economy remained stable (Rodriguez – Boetsch 2005, p.302). Moreover, the country underwent privatization, deregulation, and trade liberalization (Rodriguez – Boetsch 2005, p.302). Until the crisis in 1998, Argentina was viewed as a success story and a role model. The currency board was created to conquer inflation and create deflationary expectations among the general populace. As part of the Convertibility Plan, the board was created to enhance confidence among investors, population, and anyone in power to set prices in the Argentinean market (IMF 2003, p.4). To stabilize the economy, the board pegged the Argentine peso to the US dollar at 1:1 (Rodriguez – Boetsch 2005, p.307). Moreover, it linked the supply of pesos to the quantity of US dollars held in Central Bank reserves (Rodriguez – Boetsch 2005, p.307). Money supply depended on the US dollar reserves. Since the Argentinean peso was pegged 1:1 to the US dollar, the money supply was determined in the same way. For example, assume there was only one dollar in the Central Bank’s reserves. Then the money supply would be one Argentinean peso times the money multiplier. Now assume that an additional dollar is bought by the Central Bank and put in reserves. This increase in reserves translates into an increase in money supply. Namely, one additional peso is put into circulation. However, this is not the end of the analysis. In every economy, a stock of value changes hands several times within a given time period. Thus, this additional peso needs to also be multiplied by the money multiplier. This relationship is described in equation (1) below, where is money supply, is monetary base and is the money multiplier (Gokbudak 1995, p.111). (1) Money multiplier, in return, is determined by the required reserve ratio (Rodriguez – Boetsch 2005, p.308). This definition can be seen in equation (2), where is the money multiplier, and is the required reserve ratio determined by the Central Bank. (2) The board eliminated previously available options. Monetary policy was no longer an option. Under a floating regime, the central bank can sell or buy securities and so through open market operations control the interest rate, which in turn determines the cost of money and can offset inflation. Since this policy was not an option, only fiscal policy remained. The labor market also needed to become flexible in order to absorb some of the possible shocks (IMF 2003, p.8, 26). However, with 70 percent of federal budget going to social security and provinces, little maneuve ring space was left for the fiscal policy (IMF 2003, p. 13). There are several causes of the crisis. The IMF (2003) considers this crisis to have been caused by the interaction between fiscal policy and the currency board arrangement. The crisis is also seen as an outgrowth of fragile balance sheets in the undeveloped banking sector and lack of political strength to implement a reform. Public sector debt is seen as a trigger which, coupled with previous history of economic slumps, led to the above causes (IMF 2003, p. 4). Following