Question

Large Open Economy Large Open Economy: Political instability in Mexico in 1994.Discuss and explain what happens with words (abbreviations and arrows are fine) and with graphs (market for loanable funds and market for foreign currency)

Case 1: what happens to NFI, r, NX and real exchange rate in the US.

Case 2: what happens to NFI, r, NX and real exchange rate in Mexico

Answer 1

Political instability in Mexico along with large devaluation of peso (Mexican currency) in 1994 caused the Mexican financial crisis or ' Tequila crisis' which lead to banking crisis and severe recession which spanned a decade. In january 1994 a spanish revolutionary army EZLN took control of largest towns in state of Chiapas. Further there were high level political assassinations, kindapings of high profile executives. This affected investors perceptions negatively about Mexico which led to large scale capital outflows. Also US interest rates was rising gradually since february of the same year. All these incidents led to depletion of foreign reserves and worsening investor's confidence in Mexico's forex peg.

In response the Mexican government increased their borrowing as a way to manage capital flight and acculmulate forex reserves. Real exchange rate appreciated initially resulting in cheaper imports and expensive exports. Costly exports reduced export demand and worsened current account deficit. To prevent further appreciation of peso, Central bank of Mexico tried to carry out gradual depreciation and allowing peso to float with exchange rate.

Impact on -	US	Mexico
Net foreign Investment	Increased due to increase in interest rates	Large scale capital flight with nearly $5 billion out in 2 days, due to negative investor sentiments caused by political instability.
interest rate	US FED raised short term interest rates gradually in 1994.	Due to capital flight, there was shortage of money supply which resulted in increase in interest rates and many businesses started defaulting on their borrowings.
Net exports	Increase	Negative as real exchange rate appreciated initially
Real exchange rates	-	Appreciation of peso making it overvalued initially followed by devaluation of peso by Central Bank of Mexico