Question

In the late 1970s, several countries in Latin America, notably Mexico, Brazil, and Argentina
had accumulated large external debt burdens. A significant share of this debt was denominated in U.S. dollars. The United States pursued contractionary monetary policy from
1979 to 1982, raising dollar interest rates. How would this affect the value of the Latin American currencies relative to the U.S. dollar? How would this affect their external debt in local currency terms? If these countries had wanted to prevent a change in their external debt, what would have been the appropriate policy response, and what would be the drawbacks?

Answer 1

Contractionary monetary policy in the United States would lead to an appreciation in the U.S. dollar comparative to other moneys. This would upsurge interest rates in the United States, rise dollar-denominated obligations, and thus decrease external wealth in Latin America (supposing a lesser portion of external assets are dollar-denominated). The appreciation of the U.S. dollar would upsurge the size of interest payments for Latin American countries both because of higher interest rates and since their currencies were comparatively feebler against the dollar. To avert the diminution in external wealth, countries would have had to track the United States and decrease their money supplies to increase domestic interest rates and avert the depreciation in their local currencies against the dollar. The disadvantage of this retort is that it would need a contraction in output, pushing output below its desired level