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By the late 1970s, several countries in Latin America, including Chile, 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 in the early 1980s increased interest rate and sparked sovereign debt and currency crises in several Latin American countries. This exercise walks you through the crisis and the various policy options of the central bank. For all the exercises below, take Mexico to be the home country and the USA to be the foreign country, whose variables are denoted with a . Mexicos currency is initially pegged to the US$ at a fixed exchange rate Ep0esos/US$.

In the three scenarios below, illustrate the effect of the increase in R on the Mex- ican money market and foreign exchange market. In each scenario, specify what happens to official foreign reserves and money supply. Label axes clearly

(a) Scenario 1: The central bank maintains the peg.

(b) Scenario 2: The central bank devalues the currency.

(c) Scenario 3: The central bank maintains the peg, but imposes controls on the flow of capital. That is, it prohibits Mexican nationals from freely buying and selling US dollars. In your graph, capital controls will allow for a wedge between the returns on dollar and pesos deposits at the ongoing exchange rate E0.

(d) Compare the effects of the different scenarios on Mexican employ- ment. Briefly explain your answer.

(e) Compare the effects of the different scenarios on the Mexican sovereign debt.

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