THE MEXICAN PESO CRISIS - SUDDEN-DEATH OR DEATH FORETOLD

We argue that allowing for the possibility of a self-fulfilling panic helps to understand several features of the recent Mexican crisis. Sel f-fulfilling expectations became decisive in generating a panic only a fter the government ran down gross reserves and ran up short-term doll ar debt. We present a simple model to explain how and why multiple equ ilibria can occur for some levels of reserves or debt, but not for oth ers. Lastly, we argue that the imperfect credibility of Mexican exchan ge rate policy made it advisable to follow more contractionary fiscal and monetary policies in 1994. Our model formalizes the reasons why th is is so.