Problem 7.2 Crisis at the Heart of Carnaval

a. What should have been the exchange rate in January 2003 if PPP held?b. By what percentage was the Argentine peso undervalued on an annualized basis?c. What were the probable causes of undervaluation?

Assumptions ValueSpot exchange rate, fixed peg, early January 2002 (Ps/$) 1.0000 Spot exchange rate, January 29, 2003 (Ps/$) 3.2000 US inflation for year (per annum) 2.20%Argentine inflation for year (per annum) 20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps/$) 1.00 Argentine inflation 20.00%

US inflation 2.20%PPP exchange rate 1.17

b. By what percentage was the Argentine peso undervalued on an annulized basis?

Actual exchange rate (Ps/$) 3.20 PPP exchange rate (Ps/$) 1.17

Percentage overvaluation (positive) or undervaluation (negative) -63.307%

c. What were the probable causes of undervaluation?

The rapid decline in the value of the Argentine peso was a result of not only inflation, but also a severe crisis in the balance of payments (see Chapter 4).

The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$. During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized.