The peso problem and dollar hegemony under inflation targeting

Abstract

This article examines the influence of US monetary policy on Mexico’s exchange rate (peso/dollar) and monetary policy. It shows that the recent reduced volatility of Mexico’s exchange rate is a consequence of defensive policies undertaken by Mexico’s central bank to avoid sudden capital reversals and speculative attacks, usually associated with destabilizing speculative behavior. To test that hypothesis, the paper examines the effect of the accumulation of international reserves and exchange-rate variations on the Mexico–US interest-rate gap. The authors’ findings confirm that international reserves permit the central bank to maneuver the exchange rate and its inflation target. Furthermore, the paper provides an estimated Taylor rule for Mexico, including the US interest rate. The estimation reveals that Mexico’s monetary policy is not independent of US monetary policy. Mexico faces a liquidity trap at a higher interest rate than the United States. Whereas the United States faces a trap at the zero lower bound, Mexico encounters monetary policy ineffectiveness at an interest rate of 3.5 percent.