**Research Discussion Papers, Bank of Finland**
# No 24/1998:

Simulating the Effects of Imperfect Credibility: How Does the Peso Problem Affect the Real Economy?

*Veli-Matti Mattila *()

**Abstract:** In this paper we analyse the macroeconomic effects of peso
problems by simulating numerically a small-scale rational expectations
macromodel. The model is a conventional IS-LM-AS model of an open economy
under floating exchange rates. The peso problem has been incorporated in
the model by assuming that the money supply process entails a small but
nonzero probability of a sizable discrete shift in the money supply. In
addition, the severity of a peso problem can vary over time. The procedure
used in solving our model is more complicated than the standard solution
methods for rational expectation models in that there are two dates at
which expectations are formed.

Both deterministic and stochastic
simulations were used in the analysis. Results from the deterministic
simulations suggest that the presence of the peso problem leads to an
overvalued real exchange rate and a higher ex ante real interest rate,
which results in output losses. In the stochastic simulations, the values
of the IS, AS and monetary disturbances vary along with the severity of the
peso problem. The simulations show that the presence of a variable peso
problem affects the correlations between macroeconomic variables,
especially between the ex post yield differential and either the real
exchange rate or the output gap. In the case of conventional
(non-autocorrelated) IS, AS and monetary disturbances, these correlation
coefficients are equal to zero. The inclusion of a variable peso problem in
the simulation model changes these results: the ex post yield differential
is now correlated with the real exchange rate and the output gap.

In
the empirical part of the paper we demonstrate the applicability of our
simulation results using Canada and the United Kingdom as examples.

**Keywords:** peso problem; credibility; simulation; (follow links to similar papers)

49 pages, November 13, 1998

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