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    Argentina's ability to maintain currency convertibility

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    Following the Mexican devaluation, investors questioning Argentina's ability to maintain currency convertibility began pulling their money out of Argentina. In response, the Argentine government took extraordinary steps to maintain its exchange rate at $1 per peso.

    a. What were the likely consequences of this capital flight for Argentina's peso money supply? for Argentine peso interest rates? for economic growth?

    b. Why was the Argentine government so reluctant to devalue the peso?

    c. As U.S. interest rates rise, what is likely to happen to Argentine rates? Why?

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    Solution Preview

    a. What were the likely consequences of this capital flight for Argentina's peso money supply? for Argentine peso interest rates? for economic growth?

    Since Argentina maintains a currency board, it cannot sterilize the effects of currency inflows or outflows. An outflow of capital, therefore, must lead to a decline in the quantity of pesos in circulation. The immediate impact was a jump in interest rates. In turn, high real rates led to a slowdown in economic growth. However, as investors became convinced that Argentina was not going to ...

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