Question

In general what (situations) and incentives faced by government make it difficult to keep a fixed exchange rate. Why did Mexico fail to defend its 1 peg? What was the state of Mexico’s reserves relative to their money supply at the time they defaulted? How about their budget deficit? Why did they default anyway.

Answer 1

The Mexican peso crisis was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by capital flight.In response, the Mexican central bank intervened in the foreign exchange markets to maintain the Mexican peso's peg to the U.S. dollar by issuing dollar-denominated public debt to buy pesos. The peso's strength caused demand for imports to increase in Mexico, resulting in at Speculators recognized an overvalued peso and capital began flowing out of Mexico to the United States, increasing downward market pressure on the peso.On December 20, 1994, newly inaugurated President Ernesto Zedillo announced the Mexican central bank's devaluation of the peso between 13% and 15%.Devaluing the peso after previous promises not to do so led investors to be skeptical of policymakers and fearful of additional devaluations. Maxicos economy a severe recession as a result of the peso's devaluation and the flight to safer investments. The country's GDP declined by 6.2% over the course of 1995. Mexico's financial sector bore the brunt of the crisis as banks collapsed, revealing low-quality assets and fraudulent lending practices.

A more common scenario occurs when excessive budget deficits lead to currency overvaluation and, eventually, to devaluation. The deficits, financed atleast in part by monetary expansion, generate inflationary pressures. Pegging the exchange rate holds
down the domestic rate of inflation temporarily by containing increases in the prices of imported goods as well as domestic goods that compete heavily with import
However, the economy runs continuous current
account deficits that deplete foreign exchange reserves. At the same time, capital outflows further deplete reserves unless effective capital controls are in. place Eventually, reserves become so small that devaluation becomes virtually inevitable.