Market sentiment and macroeconomic fluctuations under pegged exchange rates

The effects of an adverse change in market sentiment, defined as a temporary increase in the premium faced by domestic borrowers on world financial markets, are studied in an intertemporal optimizing framework with imperfect capital mobility. Firms' demands for working capital are financed by bank credit. The shock leads to a rise in domestic interest rates, capital outflows and a drop in official reserves, a reduction in bank deposits and loans, a contraction in output, and an increase in unemployment. These predictions are consistent with Argentina's economic downturn in the immediate aftermath of the Mexican peso crisis of December 1994.