Policy fundamentals, interest rates differential, and expected devaluation in the presence of an active crawling peg system

Abstract

One of the most interesting theoretical issues that comes up from the analysis of the tablita period in the Southern Cone economies—Argentina, Chile and Uruguay—is the interpretation of why interest rates on domestic currency loans were much higher than the rate on foreign currency loans adjusted for devaluation of the domestic currency, even though the rate of devaluation was set by the monetary authorities six months ahead and published in a little table ( tablita). This was particularly puzzling in the case of Uruguay which had practically perfect capital mobility. We show that the reason rational economic agents were willing to pay high domestic interest rates rather than borrowing in foreign currency was that they realized that policy fundamentals were inconsistent with the sustainability of the exchange rate policy. Using data for Uruguay we show that a second systematic component of expectations of devaluation is what we call ‘the policy risk factor’ and modeled as a function of the fiscal and monetary variables. (JEL 41, 31).