Salvation Takes More Than a Floating Peso
Subject Exchange rates, economic growth
Topic International Finance
Key Words Devaluation, Exchange Rates, Default, Economic Growth
News Story

On February 11, Argentina allowed the value of the peso, its national currency, to be determined by international foreign exchange markets. Argentina is hoping that a devaluation of the peso will promote export growth and provide sufficient stimulus to end Argentina's four-year recession. Economists believe that much more is needed in order for this goal to be accomplished citing political stability and fiscal reform as examples. In addition, the government and its major corporations need to support the devaluation with policies that make exporting more attractive and lucrative. Analysts believe that even if supporting measures are adopted, improvements in the Argentine economy will take years, not months to accomplish.

After Argentina dropped the 1-to-1 dollar to peso peg that had determined Argentina's exchange rate for a decade, it adopted a two-tiered exchange rate system. Under the dual system, exports were priced at a fixed rate of 1.4 pesos to the dollar, while non-trade transactions were determined by a floating rate that is currently at 2.05 pesos per dollar. Starting February 11, the value of the peso is to be freely determined in exchange rate markets.

The devalued peso, which economists believe will settle at 2.5 pesos per dollar, will aid exporters and provide needed stimulus to Argentina's ailing economy. Argentina hopes that its devaluation will make the export sector the catalyst for economic growth. In order to reorient its economy, the government needs to support the devaluation with other incentives such as tax reform. Major corporations, according to analysts, do not have the marketing know-how, international relations and ability to adjust to international quality standards.

The central government has started the fiscal reform process and has negotiated with its provincial governments to reduce public spending. A more reliable banking sector and political stability are additional changes that would aid in the transformation.

(Updated March 20, 2002)

1. The Argentine government believes that growth in exports can provide the stimulus to economic growth that is badly needed. Explain using the concept of the multiplier how an increase in exports generates additional economic growth.
2. How does a devaluation encourage a country's exports? What happens to imports a result of the devaluation?
3. When the peso was pegged to the dollar in a fixed ratio, the government could only expand the supply of pesos if it had a sufficient number of dollars. With the peso free to float, what happens to ability to increase the number of pesos?
Source Michelle Wallin, "Analysts Warn That a Free-Floating Peso Is Only Part of the Fix That Argentina Needs," The Wall Street Journal, February 8, 2002.

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