In the spring of 2002, Argentina was forced to devalue its peso and disband its currency board that was responsible for the fixed exchange rate between the peso and the U.S. dollar. Explain the origin of this crisis and the painful remedies that Argentina has had to endure

Answer 1

Argentina was maintaining a fixed exchange rate to the dollar. At the same time, they were running substantial balance of payments deficits and thus losing foreign reserves. They were losing foreign reserves because, under a fixed exchange rate system, governments are obliged to buy their own currencies to maintain the "pegged" value of the currency. By definition, a balance of payments deficit means that the quantity demanded of foreign currency exceeds the quantity supplied of foreign currency in the foreign exchange market. To prevent the exchange rate from falling, the Argentinean government had to step in and supply foreign exchange to make up for the excess demand. Inevitably, it would soon run short of foreign currency and thus be faced with a dilemma. The government could either generate recessions to decrease demand for foreign currencies or devalue their currencies and, thereby increase the price of imports and increase the cost of living in their own countries. In the end, both things happened. The Argentinean government was forced to devalue its currency and undergo a painful recession and the attendant increased unemployment and declining income. Many economic observers now propose several reforms in the international financial system to avoid such occurrences in the future.