Question

In the late 1970s, several countries in Latin America, notably Mexico, Brazil, and Argentina, had accumulated large external debt burdens. A significant share of this debt was denominated in US dollars. The United States pursued contractionary monetary policy from 1979 to 1982, raising dollar interest rates.

As a result, Latin American currencies [ depreciated / appreciated ] , and hence their external debt in local currency terms [ decreased / increased ]. A way to prevent this change in external debt would have been to [ devalue / peg ]. However, this might have implied [ a greater increase in debt to make the new monetary arrangement work / a reccession, since they would have had to raise interest rates as well ].

Answer 1

1. Depreciated. Raising interest rates in the United States will lead to appeciation of dollar and as dollar appreciated in terms of Latin American currencies, the Latin American currencies would depreciate.

2. Increased. Depreciation of currency increases the foreign debt burden of the government if the domestic government has external debt accumulation.

3. Peg. Pegging the currency would help to prevent change in the value of external debt to be rising and keep it within the band.

4. A recession. This might lead to recession in the economy because pegging would imply that interest rates will have to be increased to keep exchange rate within the limit.