In 2001, the government of Argentina faced large expenditures and tax revenues were low due to a recession, so Argentina was running a deficit. Printing money to pay for the deficit was not possible since Argentina had a currency board, which fixes the amount of cash which can be printed. Further, the government could not borrow abroad to finance the deficit. Foreign investors refused to lend because they feared Argentina would default. Therefore, the government forced local banks to make loans to the government. The government lowered the required reserve ratio, took the existing bank reserves, and gave the banks I.O.U.’s (bonds) which the government later defaulted on. Since the reserves were gone, the local banks were unable to repay depositors and went out of business.
a. At the end of the day, who paid for Argentina’s deficit? (2 points)
b. How should have depositors responded if they believed ahead of time that Argentina would default on the I.O.U.’s (bonds)? (2 points)
c. Suppose depositors responded as in your answer to (b). What happens to:
1. the currency-to-deposit ratio? Why? (2 points)
2. the money supply? why? (2 points)
3. the price level? Why? (2 points)