Question

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. 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?

Answer 1

Jan 2002 exchange rate = 1 P/$

Jan 2003 exchange rate = 3.2P/$

If Purchasing power parity holds, then the exchange rate =1 * [ ( 1+20%)/(1+2.2%) ]= 1.2/1.022 = 1.1839

Undervaluation % = ( 3.2-1.1839) / 1.1839 = 2.0161/1.1839 = 170.3% undervaluation

The possible causes for undervaluation are that since the central bank of Argentine is pumping in USD to maintain the exchange rate, the moment Peso is floated, the central bank no longer has spent money to keep it constant (which saved the bank a lot of money to be pumped into the economy). This would have caused the chronic undervaluation of the Argentine Peso.