DP1241 | The Macroeconomics of the Mexican Crisis: A Simple Two-period Model

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We analyse the events leading to the devaluation of the Mexican peso last year, using a simple two-period model. We view the problem as a race between a foreign investment led demand boom and the potential expansion in supply which might follow; the outcome of such a race is inherently uncertain. If, in an exchange rate based stabilization programme, supply does not keep pace with demand, competitiveness problems will eventually result in lower output, and consequently the government might be tempted to devalue. In Mexico it would also appear that the costs and benefits of maintaining the regime were adversely affected by a reduction in the amount of external financing available.