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Abstract
From 1991 to 2002, Argentina engaged in an economic stabilization strategy, the "Convertibility Plan," that fixed the national currency to the U.S. dollar. This article analyzes how the counter-cyclical role of domestic interest rates contributed to the Plan's collapse, as it changed investors' confidence on the commitment of policymakers to continue with unpopular recessionary and deflationary adjustment policies. To reach this conclusion, this article - using univariate and multivariate techniques (cointegration) with monthly data from 1991 to 2002 - examines the dynamic behavior of domestic inflation and interest rates in the context of the currency board. In the absence of nominal exchange rate flexibility, other variables adjusted to ensure equilibria in both the goods and services and the capital markets. Following a similar dynamic to the one analyzed under the Convertibility Plan, and taking into consideration the finding that Argentine prices adjust to keep the real exchange rate constant in the long run, the current strategy of keeping a "competitive exchange rate" has an obvious downside: the impossibility to control inflation.
Keywords: PPP, UIP, Cointegration, Argentina, Convertibility Plan
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Introduction
After the hyperinflationary processes of 1989 and 1991, Argentina engaged in an exchange ratebased economic stabilization strategy that fixed the national currency - the peso - to the dollar, known as the Convertibility Plan.
The logic behind convertibility was that, since the nominal exchange rate was fixed at a parity of 1:1, Argentina's inflation rate should decrease and converge to the United States' level, assuming that purchasing power parity (PPP) would hold. The counter-inflationary benefits of fixing the exchange rate to the dollar would come from the reputation of the U.S. Federal Reserve in pursuing a sound monetary policy. Along with price stabilization, the currency board would promote the convergence of domestic interest rates to the reserve currency levels. During an adverse shock, or with an overvalued peso, imports would exceed exports. With the Central Bank simply converting the extra pesos into dollars, the money supply would decrease. Liquidity constraints would drive interest rates higher. A higher interest rate would dampen investment and economic activity, until imports dropped. High domestic interest rates would attract capital inflows and thereby ease the contraction of the economy, making the local currency...