Question

2. Suppose the following. The Argentinian government undertakes extensive borrowing by issuing U.S. dollar denominated bonds. (Let’s say investors think Argentinian peso denominated bonds would be higher risk.) To keep the size of its debt repayments low, the Argentinian government decides to peg (fix) the peso to the dollar, and it does so at an exchange rate where the peso is stronger than the market exchange rate.

(a) To bring about the desired fixed exchange rate, which would the Central Bank of the Argentine Republic do, buy foreign currencies or sell foreign currencies?

(b) Suppose financial markets expect that, in the near future, the Argentinian central bank will run out of the currency needed to pursue its fixed exchange rate regime. What will currency traders do, buy the peso now or sell the peso now?

(c) Let’s say the Argentinian central bank runs out of the currency it needs for fixing the exchange rate. Given the actions of currency traders in (2b), does peso appreciate or does it depreciate?

(d) Given an expectation of the change in the peso strength in (2c), what happens to the amount of financial capital in Argentina?

(e) What happens to the interest rate in Argentina?

(f) What happens to production and employment of Argentina?

(g) What could Argentina do to respond (at least temporarily) to the situation where it can’t make payments (using foreign currencies) to buy foreign products and foreign parts or make repayments on its dollar denominated debt?

Answer 1

Answer 2(a): To bring about the desired fixed exchanged rate, the Central Bank of Argentine Republic will sell foreign currency. When it sells its foreign currency, it will reduce the supply the availability in the local markets, which will directly boost the value of its Peso.

Answer (b) : If the traders in the financial markets expect that in the longer run, the Argentinian Central Bank will run out of the currency that it needs to pursue its fixed exchange rate regime, the traders will sell peso now, as they will expect that as soon as the Argentinian Central Bank runs out of the held currency, the value of Peso will drastically fall, thus reducing their profits.

Answer (c): Since the Argentinian Central Bank has run out of the currency that it needs to pursue its fixed exchange rate regime, the value of Peso will drastically fall, and the Peso will depreciate to a very lower value

Answer (d): Since the Argentinian Central Bank has run out of the currency that it needs to pursue its fixed exchange rate regime, the value of Peso will drastically fall, and the Peso will depreciate to a very lower value, it will reduce the amount of financial capital of Argentina to a very less value.

Answer (e): Since the value of Argentinian Peso has fallen sharply, the interest rates in Argentina will rise heavily, since the Government and the Central Bank will now need to accrue huge amount of Peso to regain the market status again.

  Answer (f): With the fall in the value of Peso and the interest rate rising, the production process in Argentina will suffer a major blow and will reduce drastically, as the producers will not want to incur losses by investing further amount of money. Employment will also be directly impacted, as the employers will no longer want to employ those laborers who will cost them higher unnecessarily.

Answer (g): In the shorter run, the Argentinian Government and its bank should buy the foreign capital, which will increase the value of its Peso in the market. As the value of peso increases in the market, the exchange rate will be higher, thus enabling the market to stabilize.