Reference no: EM131368098

Assignment

The Limits to Macroeconomic Policy

In 1900, Argentina was among the richest countries in the world. Its good fortune was not to last, however, and by mid-century its per capita income had fallen behind. Although it still had the highest per capita income in Latin America, the gap with western Europe and North America was substantial, and it was not get- ting smaller when it was hit by the Latin American debt crisis and the Lost Decade of the 1980s (see Chapter 15). The debt crisis was vicious and hard to shake off. In 1989, seven years after it began, Argentina was still caught in it, and its GDP fell 7 percent while inflation hit 3,080 percent. Politicians tried a variety of experiments to get out of the recession and hyperinflation, but none of them led to sustained growth or brought down the inflation rate.

In 1991, a radical experiment was tried. The country fixed its currency to the dollar at a 1:1 rate and dramatically restricted the creation of new money. For every new Argentine peso put into circulation, the central bank was required to have a dollar to back it up, and a newly created currency board was there to oversee the exchange rate system and enforce the rules. The currency board worked extremely well through most of the 1990s. Argentina was back on a strong growth path with low inflation and was widely viewed as a successful model for other countries. Problems began to develop in 1998, however, when the global fallout from a crisis in East Asia spread to Latin America. Argentina's main trading partner, Brazil, devalued its currency in early 1999, giving Brazilian firms an advantage and putting Argentine firms at a disadvantage since goods valued in pesos were now more expensive. Argentina's cur- rent account balance developed a relatively large deficit of 4-5 percent of its GDP, and the loss of exports led to a recession in 1999. At this point, conventional economic theory prescribed a demand-side stimulus for Argentina.

Total expenditures in the economy were down, in part because it was more difficult to export, so the country should have cut taxes, raised government spending, increased the money supply, or some combination of those policies. There were a few obstacles, though. First, anything that might upset the 1:1 exchange rate was viewed as a potential problem. All else equal, expansionary macroeconomic policies cause prices to rise, and it was feared that deliberately increased government deficits might undermine confidence in the anti-inflation commitment of the government. Argentina was already running a budget deficit that was hard to control, and increased spending and tax cuts were not an option. Monetary expansion was also out since that would undermine the peg to the dollar by increasing the circulation of pesos beyond the level of dollars available to back them up.

Secondly, a currency devaluation, whether intentional or not, would be a problem. During the growth years of the 1990s, Argentine firms and Argentina's government had borrowed dollars in international capital markets. There was nothing particularly unusual about Argentina's borrowing, except that its ability to raise revenue to service its debts was constrained by domestic political factors. Taking on debt denominated in dollars is common, but it imposes a high price when there is a currency devaluation, since the dollar value of the debt does not change, but the domestic currency value rises. Given that the government and most firms earned revenues in pesos, but that their international debts were in dollars, anything that caused the value of the peso to decline would increase the burden of debt. The debate over policy was intense: Should Argentina devalue and increase the debt burden or maintain the exchange rate and continue to watch the current account deficit grow and the economy shrink? Cut government spending to create confidence in the fiscal soundness of the government; or, use expansionary fiscal policy to address the recession while undermining confidence in the government' commitment to the 1:1 exchange rate? In effect, there were two choices. On the one hand, the government could use expansionary macro- economic policies to try to combat the recession, but at the cost of a probable devaluation of the peso since no one would believe that it was still committed to anti-inflation policy and fiscal prudence. On the other hand, it could maintain the peso's link to the dollar at the 1:1 ratio, but at the cost of ignoring the recession. Argentina's recession began in 1999. Two year later, in 2001, the country was still in recession and prospects seemed to be getting worse. As people lost confidence in the government's ability to maintain the 1:1 exchange rate, they decided that a devaluation was coming and began to take their money out of banks. After enormous losses in the banking sector, the government closed all banks in early December 2001.

When they reopened in January 2002, the peso's link to the dollar had been cut. The peso began a steady decline, dropping from 1 peso per dollar to 0.7 pesos on January 7, to 0.545 pesos on January 22, and on down in value. Eventually, around June 2002, it stabilized around 0.27 pesos per dollar. In the end, it lost about three-fourths of its value. Some observers argue that Argentina should have sought more flexibility in its policies by severing the one-to-one relationship between the peso and the dollar much earlier-in 1997 or 1998. Others argue that it should have made deeper cuts in its budgets, because that was the only way to maintain confidence in its currency. At first, the government tried the latter approach, but political and institutional obstacles prevented the budget cuts from being large enough. The Argentine case still poses questions for economists. Recessions caused by a decline in demand are most effectively fought by increasing demand, either through government spending, tax policy, or monetary policy. However, if a country needs to demonstrate to the world that it is fiscally prudent because doing so will prevent speculation against its own currency and maintain the inflow of foreign currency, then expansionary macroeconomic policies may be impossible. Does this mean that developing countries cannot use expansionary macroeconomic policies?

1. Write a 5 page paper (1500 or more words) in APA format in response to the questions:

Below is a recommended outline.

2. Cover page (See APA Sample paper)

3. Introduction

a. A thesis statement
b. Purpose of paper
c. Overview of paper

4. Body (Cite sources using in-text citations.)

a. Provide an overview of this case analysis; summarize the key points.
b. Explain why a currency devaluation, whether intentional or not, would be a problem.
c. Consider the question: Does this mean that developing countries cannot use expansionary macroeconomic policies? Provide an answer to this question.

5. Conclusion - Summary of main points

a. Lessons Learned and Recommendations

6. References - List the references you cited in the text of your paper according to APA format.

(Note: Do not include references that are not cited in the text of your paper)