Exchange Rates: The Mexican Peso Crisis and Policy Solutions

Objective: This task aims to help IB economics students analyse the Mexican Peso Crisis using economic theory, demonstrate their understanding of fixed and floating exchange rates, and propose policy recommendations to address specific problems that existed in the aftermath of the crisis.

Background Information:

The Mexican Peso Crisis, also known as the Tequila Crisis, occurred in December 1994 when the Mexican government devalued the peso against the US dollar, leading to a rapid depreciation of the peso and a severe economic crisis in Mexico. 

The decision to devalue the peso was in response to a rapid decline in investor confidence in Mexico. What had been a great year for FDI following the signing in of NAFTA in January 1994, things began to go sour after the country became rocked by violence and political instability. The devaluation of around 13% only rocked the economy further. The fixed exchange rate system was abandoned two days later which then led to a collapse of the peso and further depreciation.

The crisis was triggered by a combination of factors, including Mexico’s fixed exchange rate system, a large current account deficit, capital flight, and dwindling foreign exchange reserves.

  1. Fixed Exchange Rate System: Prior to the crisis, Mexico maintained a fixed exchange rate system in which the value of the peso was pegged to the US dollar within a narrow band. This system helped to stabilize the exchange rate and reduce inflation. However, it also made Mexico’s economy vulnerable to external shocks and speculative attacks.
  2. Current Account Deficit: Mexico’s current account deficit widened in the years leading up to the crisis, primarily due to increased imports and a lack of competitiveness in export markets. This deficit required financing through capital inflows, such as foreign direct investment and short-term portfolio investments.
  3. Capital Flight: In the months before the crisis, political and economic instability in Mexico led to capital flight, as investors pulled their money out of the country. This reduced the supply of foreign currency, putting pressure on the exchange rate and the central bank’s foreign exchange reserves.
  4. Dwindling Foreign Exchange Reserves: Mexico’s central bank attempted to defend the fixed exchange rate by using its foreign exchange reserves to buy pesos and support the value of the currency. However, as the reserves dwindled, the central bank’s ability to maintain the peg became increasingly difficult, eventually leading to the decision to devalue the peso.

Impact of the Crisis:

The devaluation of the peso led to a significant depreciation of the currency, which in turn affected the Mexican economy in various ways:

  1. Inflation: The depreciation of the peso increased import prices, leading to higher inflation. This reduced the purchasing power of consumers and increased the cost of living.
  2. Unemployment: The crisis led to a contraction in economic activity, resulting in higher unemployment rates as businesses closed or downsized.
  3. Balance of Trade: The depreciation of the peso made Mexican exports cheaper and more competitive in international markets, while making imports more expensive. This led to an improvement in Mexico’s balance of trade as exports increased and imports decreased.
  4. GDP: The crisis caused a sharp decline in Mexico’s GDP as a result of reduced consumer spending, lower investment, and decreased government revenues. The crisis also led to a recession, which lasted until 1996.

In the aftermath of the crisis, Mexico implemented various economic reforms to restore investor confidence and stabilize the economy. These reforms included fiscal consolidation, strengthening the banking system, and promoting greater transparency in economic policymaking.

Student task:

  1. Using economic theory, draw diagrams to illustrate the impact of the Mexican Peso Crisis on the foreign exchange market and the Mexican economy. Your diagrams should include the demand and supply of the Mexican peso, the exchange rate, and relevant economic indicators such as inflation, unemployment, and GDP.
  2. Write a brief commentary explaining the difference between fixed and floating exchange rates, and discuss the advantages and disadvantages of each system in the context of the Mexican Peso Crisis.
  3. Review the table below, which outlines five specific problems that emerged in the aftermath of the crisis. In the right-hand column, propose a policy solution for each problem, taking into consideration the potential benefits and drawbacks of each recommendation.