Category Archives: Monetary Economics

Money and Interest

In a barter economy with no money, it is easy to see how value and purchasing power come about: a person must produce or acquire something, whether a good or service, that someone else would want to exchange another good or service for. This is explained by Say’s Law.

Interest is evident in a barter economy as the ratio of current goods demanded to future goods. This is the result of time preference, and shows that interest is not a monetary phenomenon but is the result of scarcity both in goods and time.

The situation is complicated by the use of commodity money in an economy, and even more so when fiat money is used that is not restricted in quantity by anything but government discretion.

What Kind of Good is Money?¹

Is money a production or consumption good? The loss or gain of a production or consumption good makes society worse or better off than before, but an increase or decrease in the supply of money cannot change society’s welfare, since it will only decrease or increase the purchasing power of existing money and will leave the overall value of all money unchanged.

No part of production or consumption is dependent on money, despite the fact that money greatly increases the ease of exchange. The laws governing production and consumption goods are different than those governing money; they share only the basic laws of value. Economic goods should therefore be divided into means of production, objects of consumption, and media of exchange. These definitions will help to answer the question of whether or not money is capital, and help to elucidate the relation between the equilibrium (which is determined only by individuals’ time preferences) and money rates of interest.

What is the connection between private capital and money? Private capital is the aggregate of products that are used to acquire other goods. Money on loan bears interest, but produces nothing per se otherwise. The borrower of money, however, exchanges it for economic goods, as do other holders of money. Money is then part of private capital insofar as it is used as a means to obtain other capital goods.

Social capital is the aggregate of goods intended for use in further production, and money cannot be included since it is not a productive good. The fact that the rate of interest is determined by the quantity of economic goods and not the quantity of money means that money is not a productive good.

Commodity Money²

The differences in money and commodities become obvious when looking at money’s objective exchange value, or purchasing power. While money ultimately derives its value from the subjective valuations of people, as do all commodities, its subjective value is strongly affected by its objective exchange value, and is not so strongly affected by its objective use value and its place in the hierarchy of human needs as other goods are.

Subjective use and exchange values coincide in money since both are derived from its objective exchange value and money has no other use than in obtaining other economic goods. The subjective use-values of commodities must be taken for granted and left to the psychology of each individual, but the analysis of money begins where the analysis of commodities stops, since money has no subjective value apart from its exchange value, and this comes from the subjective valuations of the goods for which money can be exchanged. It is important to note that the exchange value discussed here, and which is derived from the individual subjective values placed on them, is not the same as the value theory of Smith and Ricardo and the Classical School, which took value in exchange as the starting point and which is derived from labor cost or cost of production (Marx used Smith’s labor theory of value to show the exploitation of the workers).

The price of money then is the amount of goods which money can be exchanged for. Commodity values are explained by subjective use-value, but money only has value insofar as it can be exchanged for goods, and therefore has an objective exchange value, or price. The objective and subjective values of money are linked.

Producers of goods focus on the exchange values of goods rather than on their use-values, which are subjective. It is, however, the sum of the use-values placed on goods by all people in the market for those goods which determines the exchange values of those goods.

Money, however, cannot be traced back to any underlying aggregate use-values which are not tied to its own objective value which is in turn tied to the values of all the goods for which the money can be exchanged.

It was thought that the value of money depended on the economic use of the material of which it was made, but this cannot account for fiat money or credit money. Monetary theory must remove all determinants of value which are tied to the money’s material, since these determinants make money indistinguishable from commodities. Only the objective exchange value is important in monetary theory, as the economic value of its material can be explained by the standard tools of economics.

What gives money its value? Fundamentally, it is the fact that market participants accept it as a medium of exchange; without this its value would collapse. But given its acceptance, it has value as a medium through which the value of labor and goods are transferred between people. A currency increases in value when more labor is undertaken in exchange for that currency and more goods denominated in that currency are traded. An example is the desire of the US government to continue the pricing of international crude oil trading in dollars. A less known example is the benefit to the dollar from having most illegal drugs priced in dollars worldwide. Both of these increase the demand for dollars and therefore its value. Holding supply constant for a currency, a greater amount of economic activity denominated in that currency increases its value.

Fiat Money

If the creator of the fiat currency, the government, decides to create more, it can essentially steal a proportion of the stored economic activity in that currency. It can use the new money at the current value, before its market value decreases due to the increased supply. Those connected to the government, who receive the money first, also benefit, as does everyone, with decreasing benefit, who acquires the money before it attains its new price based on the new supply. This is the primary benefit of fiat currencies to governments and their partners.

The Demand for Money³

The demand for money is comprised of exchange demand and reservation demand, which gives the holder of reserves optionality. Speculative demand exists when the PPM is expected to change. The increase or decrease of money held hastens the change in the PPM to its expected value.

A growing economy will experience a long run increase in the demand to hold money as more exchanges and investments are made available. Growing economies also develop clearing and credit mechanisms, which decrease the demand to hold money.

An individual’s time preference is shown in his allocation of money to consumption, investment, or to increasing his cash balance. The proportion of money to consumption versus investment is a reflection of time preference. An addition from income to the cash balance, or increased hoarding of cash, need not change the proportion devoted to consumption versus investment and therefore does not necessarily alter time preference or the rate of interest. A change in the demand for money leads to a change in the PPM, while a change in time preference leads to a change in interest rates.

Interest as Time Preference⁴

A proper understanding of the nature of interest rates is fundamental to understanding the business cycle, which is itself caused by a divergence between the real and loan rates of interest. This divergence, caused by an expansion of credit not backed by real savings, distorts the information provided by interest rates to entrepreneurs. The phenomenon of interest results from the real economy as a result of time preference, which causes, all else equal, a higher price for goods now than in the future. The pure rate of interest is the difference in value between present goods and future goods. In the production process, interest is calculated as the difference in the final good and the sum of the factors of production, which are discounted to the final goods price due to time preference. Productivity theories of interest ascribed the earning of interest to the productivity of the various factors of production. In actuality, the prices of the capital goods are based on their productivity, but the discount of their prices to the final goods they help produce is due to time preference and is the pure rate of interest.

The classical economists called profit, or interest, the return to capital, rent the return to land, and wages the return to labor, but all three are really the result of time preference and their prices are calculated from their discounted products. For example, without time preference and discounting, productive land prices would be infinite.

The pure rate of interest explains why shorter, less productive methods of production might be chosen over longer, more productive techniques. Time preference often proves a stronger force than achieving more production per input.

Contrary to some theories, interest is not determined by the supply of and demand for capital goods on the market, but determines them, along with how much of the current stock of capital goods will be saved or consumed. Interest does not cause saving, but aggregates the various individual time preferences of market participants and signals to borrowers a hurdle rate with which to analyze potential projects, and to potential savers what are the opportunity costs of consumption. So the interest rate, as a manifestation of the goods economy and individual time preferences, serves as a signal from the real economy to the money loan market and brings its interest rates in line with the aggregated time preferences of a society.

Interest in a Monetary Economy⁵

The natural rate of interest is the market rate of return to economic production, also known as the marginal efficiency of capital. The loan rate is simply a reflection of the natural rate and depends on the various expectations and decisions which economic actors make on the loan markets, stock markets, and other financial markets.

The natural rate is composed of the pure rate, which is due to time preference; the rates of return specific to various lines of production, which differ in risk, etc.; a purchasing power component which corrects for changes in the PPM during the time lag in the production process; and a terms of trade component due to the non-neutrality of money and the resulting different speeds of price change between factors of production and final goods. Only the pure rate would exist in a world without uncertainty.

The relationship between interest rate changes and price changes will be analyzed in two parts: first under the assumption of neutral money, and then allowing for non-neutrality of money.

A rise or fall in prices, meaning a fall or rise in the PPM, will cause nominal and real returns to deviate due to the time lag between the purchase of the factors of production and the sale of the final product. In a world of rising prices, rates of return will appear higher than they are. The decrease in the PPM will show that the apparent rise in profits was illusory. Because of this deviation between the nominal and real return, the natural rate of interest contains a purchasing power component which corrects for actual changes in the PPM during the production process. The purchasing power component would not exist if changes in the PPM were fully anticipated since market activity would quickly align the current PPM with the anticipated future PPM.

Changes in the PPM are never neutral, meaning they affect different goods differently. The changes alter the hypothetical array of goods which measures the PPM. Because of this, factors of production and final goods change at different speeds when the PPM changes and different factors change at different speeds, which changes the terms of trade in a production process. When product prices rise faster than factor prices, a positive terms of trade component exists in the natural rate of interest and will be reflected in the loan rate.

Changes in the PPM⁶

A change in the money relation, which is the demand for and supply of money, is non-neutral, meaning, for example, that a doubling of the supply of money will not result in a doubling of all prices. The new equilibrium between the money relation and goods will be different than the old equilibrium, apart from higher prices, and the path to that new equilibrium will not be predictable. The relative prices between goods will also be changed. Some people will gain and some people will lose. Those whose selling prices rise faster than their buying prices will gain, as will those who receive the new money before goods prices have adjusted to the new money relation. The new money will enter the economy at some points and will diffuse throughout the economy until individual prices have adjusted and a new equilibrium has been reached.

There is no gain in social utility from the new money relation resulting from a doubling of the money supply, only a transfer of some peoples’ PPM to others. There are some who gain and some who lose, and there is a possibly destabilizing path to a new equilibrium. Time preferences could also be changed since the winners will have different preferences than the losers.

The Money Supply and Goods Prices⁷

The exchange demand for goods is equal to the supply of money minus the reservation demand for money. The total demand for goods is equal to the supply of money minus the reservation demand for money plus the reservation demand for all goods. These are general and obvious relations, and it can be seen that any change in the money supply will have unpredictable consequences for the demand for any particular goods.

The exchange demand for money is equal to the supply of all goods minus the reservation demand for all goods. All of these relations are pointing to the same thing, which is the PPM. A rise in the supply of goods or the reservation demand for money cause the PPM to increase and a rise in the stock of money or the reservation demand for goods cause the PPM to decrease. An increase in demand for any particular good will cause a decrease in demand for one or more other goods absent a decrease in the reservation demand for money. A change in any specific demand for a good will not change the PPM if there is no change in the reservation demand for money.

PPM Stabilization⁸

All economic laws are qualitative. Mathematical descriptions of economic laws obscure the fact that there are no constants in human action. Mathematics relies on simplifications which cannot describe the level of uncertainty in the ever-changing magnitudes and correlations inherent in human economic activity. For this reason the quantitative methods used to stabilize or control the PPM are dubious and often harmful. These actions rely on indices which are supposed to measure a typical basket of goods available to the average consumer. This average consumer, however, has constantly changing value scales and utilities of money and goods. The attempt to stabilize the PPM through controlling the money supply will alter each individual’s value scales and will change the relative utilities of goods and the utility of money. The PPM can and should change as the utility of money relative to each available good changes. A stable PPM is actually destabilizing as it masks the natural changes taking place between money and each good and between the relative prices of all goods. Individuals holding or spending money is socially useful as it is a reflection of individual value scales. A fluctuating PPM is a natural result and reflection of this utility. Useful economic information is distorted. This fact will take on more importance when business cycles are studied.

1. See Chapter 5 of Mises’ Theory of Money and Credit.

2. See Chapter 7 of Mises’ Theory of Money and Credit.

3. See Chapter 17 of Mises’ Human Action and Chapter 11 of Rothbard’s Man, Economy, and State.

4. See Chapter 19 of Mises’ Human Action.

5. See Chapter 6 in Rothbard’s Man, Economy, and State.

6. See Chapter 11, Section 7 in Rothbard’s Man, Economy, and State.

7. See Chapter 11, Section 8 in Rothbard’s Man, Economy, and State.

8. See Chapter 11, Section 14 in Rothbard’s Man, Economy, and State.

Basic Exchange Rate Theories

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The Monetary Approach to Exchange Rates

The Monetary Approach to the Exchange Rate remedies the fixed exchange rate limitation of MABOP. Instead of monetary disequilibrium being adjusted by international money flows, as in a world with fixed exchange rates like exist under a gold standard, the MAER has flexible exchange rates leading to monetary equilibrium, as money demand and money supply, controlled by central banks, is equilibrated through exchange rate changes. A country with a managed float requires for its analysis both MABOP and MAER.

Unlike the MABOP approach, where exchange rate changes equal zero, the MAER assumes currency reserve flows are zero (with no central bank intervention) and exchange rates move instead. The relationship can be written

E’ = D’ – P'(foreign) – Y’,

which means that the change in the exchange rate equals the change in domestic credit minus the change in the foreign price level minus the change in domestic income. An increase in domestic credit by the central bank, with constant demand for money, will lead to a higher exchange rate with domestic currency in terms of foreign currency. In other words, the domestic currency is losing value relative to the foreign currency. An increase in domestic income will lead to a stronger domestic currency and a lower exchange rate, which is why Y’ and E’ are of opposite sign. An increase in the foreign price level leads to fewer imports and a stronger currency.

The Portfolio Balance Approach to Exchange Rates

The MAER assumes that domestic and foreign bonds are perfect substitutes, meaning that investors are indifferent to the currency that a bond is denominated in and care only about the return. In other words, uncovered interest rate parity holds between bonds in different currencies.

The Portfolio Balance Approach allows for imperfect substitutability, where investors do perceive currency risk and balance their portfolios accordingly. PB models contain a risk premium in forward exchange rates, and uncovered interest rate parity does not hold. As a country’s supply of bonds on the market increases, the currency’s risk premium increases, and the domestic currency depreciates. The equation describing the MAER above is modified to be

E’ = D’ + (B’ – B'(foreign)) – P'(foreign) – Y’

The additional term added to the MAER equation above, (B’ – B'(foreign)), shows that an increase in domestic bond supplies greater than a corresponding increase in foreign bond supplies will lead to a weaker domestic currency and a higher exchange rate.

Sterilization

The central bank, in a fixed exchange rate system, can attempt to maintain a money supply greater or less than money demand, which would lead to money flows out of or into the country, through increasing or decreasing the supply of domestic credit. If the central bank wants to increase the supply of money, but demand for money also increases, causing an inflow of reserves, then the central bank can sterilize the reserve inflow by increasing the supply of domestic credit by the amount of the inflow.

Under flexible exchange rates, a central bank can buy foreign bonds and sell domestic bonds, which would lead to higher exchange rates, or a depreciated domestic currency.

Source: Husted and Melvin, International Economics

Balance of Payments Theories

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National Income Accounting

A country’s current account measures the value of its trade in goods, services, investment income (not buy/sell of financial assets), and unilateral transfers. The current account indicates whether a country is a net borrower or lender to the rest of the world. The current account must be matched by a financial account, which measures foreign investment in domestic financial assets, of opposite sign. The national income accounting identity is

Y = C + I + G + X

where Y is GDP, C is consumption spending, I is investment, G is government spending, and X is the current account. This identity can be rearranged to show many things, including the fact that when savings is greater than investment there is a current account surplus, where savings includes both the private and government sectors. In other words, X = S – I. A negative X means that a country must borrow from the world to finance its imports. The current account deficit will fall when domestic spending, private or government, falls relative to domestic income.

In the absence of decreased government spending, the exchange rate and interest rate markets will cause a reduction in the current account. As the current account is financed by selling domestic securities to the world, the domestic currency is pressured downward, causing interest rates to rise, making domestic securities even more attractive. But the higher interest rates, and hence greater borrowing costs, cause a decrease in domestic spending. Domestic income increases due to the weaker currency leading to greater exports. The reduced domestic spending and higher income cause a reduction in the current account deficit.

The Elasticities Approach to the Balance of Trade

The change in the quantity demanded of foreign goods due to a change in the exchange rate of the two currencies is measured by the elasticity of demand, or the percent change in demand due to percent change in price. Elastic means the absolute value of the ratio is greater than one. Similarly, the change in amount supplied due to changes in price is measured by the elasticity of supply.

A currency devaluation should normally cause an increase in the balance of trade, but this is not always so if there are low short run elasticities. This causes what is called the J Curve in the balance of trade, where the balance actually decreases after currency devaluation before beginning to improve. This could be due to the currency contract period, when contracts enacted before the devaluation must be fulfilled. Inelastic demand for imports would also cause a J Curve. The change in domestic and foreign prices is measured by the pass through effect. The difference in profit margins between countries, and the greater pricing flexibility among higher profit margin countries, lessens the effect of a devaluation.

The Absorption Approach to the Balance of Trade

Here, the balance of trade is defined as an economy’s production less its “absorption”, or total domestic spending. Absorption has to decrease in an economy with full resource utilization for the current account balance to increase, which would allow domestic prices to fall and exports to rise. A devaluation here will produce domestic inflation as foreigners bid up the price of domestic goods. A currency devaluation could improve output and GDP, and increase the current account, while absorption remained unchanged in an economy not employing all its resources.

The Monetary Approach to the Balance of Payments

The Elasticities and Absorption Approaches have the limitation that they do not consider the financial account and instead focus on the trade in goods and services, which worked well in a world of limited capital mobility. MABOP emphasizes monetary disequilibrium in explaining balance of payments disequilibria, where monetary disequilibrium is the difference between the fiat currency supplied and the currency demanded. Excess money demand will lead to increased exports. This analysis assumes fixed exchange rates and high capital mobility.

The exports are paid for with foreign currency, which the commercial bank will exchange for dollars with the Federal Reserve. These dollars are created by the Fed and lead to an increase in the supply of base money and hence domestic credit. The demand for money can be written as

L = kPY

with L the demand for money, k a constant, P the domestic price level, and Y is real income. The demand to hold money increases with P or Y. MABOP assumes a stable demand for money. MABOP states that the percentage change in the balance of payments minus the percentage change in the exchange rate equals the inflation rate of the foreign currency plus the percentage growth of real income (Y) minus the percentage change in domestic credit (due to the increase or decrease in base money). This can be written as

R’ – E’ = P'(foreign) + Y’ – D’

The Monetary Approach assumes fixed exchange rates, so E’ = 0. With a fixed exchange rate, like a gold standard system, an increase of domestic credit by the central bank, assuming prices, income, and money demand are constant, will cause a decrease in foreign reserves. An increase in domestic credit leads to a weaker BOP as spending goes up to decrease excess cash reserves, and vice versa.

BOP problems are monetary phenomena in this world, and countries could not run perpetual deficits since they could not inflate a gold backed currency. Instead, the deficit running country would eventually run out of reserves. Domestic prices would become cheap and foreigners would buy domestic goods, and the exports would bring in currency until the system reached equilibrium again.

A domestic credit adjustment by the central bank would be used to equilibrate the BOP. Barring this, an increase in domestic income, which would strengthen the currency, would improve the BOP with domestic credit unchanged.

Regardless of the forces acting on the BOP, Gresham’s Law is always at work under fixed exchange rates and a currency managed by a central bank. People will always seek to unload overvalued currency and buy undervalued currency.

According to the MABOP analysis of currency crises, budget deficits contribute to inflation since it is known they will eventually be monetized. Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates. Exports fall while imports rise, leading to a trade deficit and capital flight. Governments must borrow to finance the balance of payments deficit, which leads to high interest payments. Each step of the cycle makes the next step worse and the cycle is perpetuated until the government capitulates.

It can be seen that in an international commodity money system, such as the gold standard, governments would not have to worry about the supply of money, or conversely they would not be able to manipulate the supply of money. In this case each individual’s money holdings is based on his marginal utility of money and flows between countries are no more important than flows between cities or individuals. Under fiat systems too the analysis must begin with the individual’s demand for money (methodological individualism versus aggregate analysis) to avoid the problems associated with the abstraction of the country.

Mexican Fiscal and Monetary History

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Mexico maintained a fixed exchange rate of 12.50 pesos to the dollar until 1976. To accomplish this, the Banco de Mexico actively intervened in the currency market to keep the peso at the desired exchange rate. The central bank would use its foreign currency reserves, usually dollars, to buy pesos. This decreases the supply of pesos on the market and increases the supply of dollars, making pesos more valuable relative to the dollar. A main reason for this is to maintain the purchasing power of the peso in order to keep imports affordable.

On the other hand, if the peso is perceived to be overvalued, the bank will sell pesos in exchange for dollars, driving the value of the peso down. Mexican exports will be more attractive with a weaker peso.

Despite continued economic growth in Mexico in the 1970s, budget deficits and inflation were rising, and deficits were financed through foreign debt. A precursor of problems to come, the peso was devalued by 56% in 1976 and taken off its fixed exchange rate in favor of a managed floating rate. In the managed floating rate system, the peso would be allowed to move within a band which would be enforced with central bank intervention.

The Mexican government, expecting increasing oil revenues from high world prices, increased borrowing in dollars. However, oil prices plummeted in the early 1980s, greatly reducing revenues and dollar inflows. Declining international economic conditions decreased demand for Mexico’s primary exports. Foreign capital, made nervous by the growing debt, began to leave Mexico, putting downward pressure on the now overvalued peso. These dollars had been used to service the growing Mexican debt, and in their absence the government announced in 1982 that it could not service its debt on billions of dollars of loans.

Neoclassical economists developed the Monetary Approach to the Balance of Payments (MABOP) theory to explain the cycle indebted Latin American countries found themselves in during the 1970s and 1980s. According to MABOP, budget deficits contribute to inflation since it is known they will eventually be monetized. Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates. Exports fall while imports rise, leading to a trade deficit and capital flight. Governments must borrow to finance the balance of payments deficit, which leads to high interest payments. Each step of the cycle makes the next step worse and the cycle is perpetuated until the government must capitulate and devalue the currency.

Miguel de la Madrid came into office in 1982, inheriting an economy in crisis and in serious need of reform after years of government intervention. The first order of business was to tackle the near 100% inflation rate. The government was able to slow inflation to around 65% by 1985 through spending cuts and tighter monetary policy, but at the cost of a 13% decrease in GDP over the same period. Another top priority was government debt reduction, which resulted in net transfers through debt payments to foreign creditors of 6% of GDP between 1982 and 1985.

Despite publicly claiming to control inflation, the government was incentivized to inflate the money supply through the existence of an “inflation tax”, which is the wealth transfer from holders of cash to the spender of newly created money, in this case the government. Money creation was such that this course of action equated to up to 8% of GDP between 1983 and 1985. By 1986, inflation had returned to its 1982 level of near 100%.

The Mexican government was still heavily involved in the economy, controlling the banking sector and limiting foreigners’ ability to invest in Mexican businesses. Government debt and controls had smothered the economy, causing a drop in per capita income in the 1980s almost as large as that seen in the Depression. Clearly, a freeing of the economy through free market policies was in order.

In 1987 and 1988, the Mexican government signed two agreements with the business, labor, and agriculture sectors popularly called the Pacto, which through its various incarnations has attempted to curb expansionary monetary and fiscal policies, control prices and wages, renegotiate debt, deregulate markets, and privatize state-owned businesses.

The Mexican public sector owned 1,155 businesses in 1982, and by 1994 940 of those were divested. The tax system was simplified, rates were decreased, tax collection and tax revenue increased, and government spending and fiscal deficits fell. The government also implemented financial and trade liberalization. The elimination of bank reserve requirements and mandatory financing of public sector businesses removed a heavy burden from private finance and allowed capital to flow to more productive areas in the economy. Banks were privatized, capital controls were lifted, and foreign capital was allowed greater access to Mexican investment. Trade liberalization came in the form of reduced import licensing and tariffs, and was codified with the passage of the North American Free Trade Agreement (NAFTA) in 1993 (Gould, 1995).

Mexico’s economic liberalization programs and successful foreign debt renegotiation in 1990 attracted capital inflows, which were made more attractive by the low interest rates seen at the time in the U.S. The financial sector’s unburdening resulted in rapid credit expansion, made possible by a large reduction in public debt and a rise in the Mexican stock market and real estate prices. Expectations of economic growth and an abundance of foreign and domestic capital led to decreased lending standards which, when faced with an economic slowdown in 1993, resulted in a rapidly increasing number of non-performing loans on the books of Mexican banks.

Local Mexican commercial banks increased credit to the private sector by an average of 25% per year from 1988 to 1994. During this same period, credit card debt rose 31% per year and mortgage loans rose 47% per year (Gil-Diaz, 1998). This local credit expansion combined with large foreign capital inflows led to rising aggregate demand within Mexico and a strengthening peso which could only lead to a current account deficit. Unfortunately, the Pacto contained within it a commitment to keep the exchange rate within a narrow band that was not in harmony with the current heated economic conditions.

With foreign money spurning low U.S. interest rates in favor of higher Mexican rates, largely in the form of short term capital, money flowed into Mexican markets. The Banco de Mexico acquired an increasing supply of dollar reserves and was able to provide the needed pesos to the market.

Predictably in an environment inundated with foreign capital and easy credit, leveraged investment began to flow to less productive projects chasing returns, increasing the fragility of the economy and leaving it vulnerable to changing international investment conditions, which occurred when U.S. interest rates rose, decreasing the demand for peso denominated investments and exposing the multitude of bad loans on the books of Mexican banks (Kaplan, 1998). As investors began to demand dollars in exchange for pesos at the managed exchange rate, Mexico’s foreign reserves began to shrink to the point that peso devaluation became necessary. The peso/dollar exchange rate went first from 3 to 3.5 pesos to the dollar, with the managed currency band still in effect. This move did not end speculative pressure on the peso, and the government increased the peso’s band. With pressure mounting, the government was forced to capitulate totally on December 22, 1994 by removing the peso’s managed float and allowing the currency to move freely against the dollar. This effectively devalued the peso from four pesos to the dollar to 7.2 pesos to the dollar in one week’s time. The U.S. government began buying pesos in an attempt to stop a collapse, and then put forth $50 billion in loan guarantees to Mexico, which were accepted and repaid ahead of schedule by 1997.