Credibility, reputation, and the Mexican peso crisis

A model emphasizing the trade-off between the costs of changes of domestic interest rates and exchange rate stability is used to assess the role of cr edibility and reputational factors in the lead-up to the December 1994 cris is of the Mexican peso. Devaluation expectations are decomposed into the pr obability that the authorities do nor truly put a high weight on exchange r ate stability and the probability that an exogenous shock will make a deval uation the preferred policy. Estimates indicate that prior to the peso coll apse there was no significant increase in devaluation fears and no perceive d shift in the authorities' policy preferences. But the increase in the dif ferential that occurred after the devaluation may have resulted from such a shift.