The Tequila effect: theory and evidence from Argentina

The Tequila Effect hypothesis states that the economic crisis that affected several South American countries in 1995 was caused by an exogenous capital flight triggered by the loss of confidence of foreign investors after the collapse of the Mexican peso in December 1994. I analyze the recent Argentine experience before and after the Mexican crisis and argue that the Tequila Effect played an important role in the 1995 crisis. I model the Tequila Effect in an optimizing, small, open economy, as a situation in which agents at time 0 learn that at some random future date foreign investors will pull their assets out of the country. The model captures key features of the Argentine crisis of 1995: the decline in aggregate domestic spending and the outflow of capital that began in December 1994; the credit crunch and interest rate hike of March 1995; the slow return of the real interest rate to its pre-crisis level, and the protracted decline in output and investment that began in March 1995.