External Shocks, Relative Prices and Sectoral Reallocation in a Small Open Economy: Evidence from Mexico

Abstract

In a small open economy external disturbances such as currency devaluations and terms-of-trade shocks seem to have a significant impact on real output. For instance, the Mexican peso crisis of December 1994 resulted in a severe economic recession: in the first quarter 1995, the Mexican gross domestic product (GDP) declined at a rate equal to 10 per cent a year. In 1997, currency devaluations in various Asian countries reduced real aggregate output. These observations appear to agree with the empirical evidence on the recessionary consequences of devaluation in developing countries noted by Edwards (1989) and Yotopoulos (1996); Mendoza (1995) found that relatively large terms-of-trade disturbances had a significant impact on aggregate output and investment levels in developing countries.