In these notes I lay out basic considerations which I believe are relevant for the design ofmonetary/exchange-rate policy, MEP, in Mexico. In my view, there are no ‘magic’ formulas.For some countries, an iron-clad currency board may be a desirable arrangement, while for othersflexible exchange rates would be appropriate. This is so because ‘money’, unlike regular goodslike bread, derives its value from convention, institutions and, more than any other good, fromexpectations. Thus, a key consideration in the design of MEP is the credibility of policymakers -- the latter being heavily determined by history and institutions which are, by necessity, countryspecific.Section II discusses some traditional goals of MEP, while Section III examines the role ofcredibility and flexibility to ensure its effectiveness. Section IV studies the recent experience inMexico and shows that the proximate case for the 1994 financial debacle was a failed attempt atinterest-rate smoothing, coupled with having ignored the role of external factors. Moreover, thissection briefly examines MEP after the crisis. It concludes that MEP is highly accommodativeand may have contributed to the existence of a “peso problem.” The latter, in turn, may give riseto further real appreciation of the currency. Section V presents a brief summary of the pros andcons of different MEPs. This is complemented in Section VI with a discussion of other policiesand considerations that are essential for the sustainability of any MEP. More specifically, I willdiscuss the role of fiscal policy, management of domestic public debt and the role of the financialsector.Section VII offers some ideas for a MEP for Mexico based on previous considerations. Ina nutshell, I propose adopting a system of flexible exchange rates, much like the present one, butwith a longer horizon and complemented with a sliding floor on the nominal exchange rate toprevent large and sudden currency appreciation. Furthermore, I argue in favor of free-floatinginterest rates and no controls on capital mobility, except for reserves requirements aimed atpreventing sudden and sizable growth in bank credit. Comparison with present MEP and somecriticisms are discussed in Section VIII. Questions about long-term goals and transition are presented in Section IX. Appendix I examines a simple formal model to rationalize the effect ofthe MEP after the December 1994 crisis, while Appendix II analyzes some technical implicationsof the proposed exchange rate rule.
