Goals and Objectives of Mexico’s Monetary Policy

Mexico’s monetary policy, directed by the Bank of Mexico (Banxico), aims to achieve two key
goals: inflation targeting and financial stability characteristics. The objectives underlying
Banxico’s strategy to foster a stable economic environment that promotes long-term growth and
resilience to financial shocks are central to these objectives.

Inflation targeting constitutes a major component of Banxico’s policy. The central bank also has
a stipulated rate, which is an annual inflation rate of 3 percent plus or minus one percentage
point, targeted at stabilising prices and enhancing economic growth. Banxico puts this target in
the spotlight, in order to control inflationary levels and a predictable economic scenario, which is
beneficial to consumers and businesses. Price stability is important to protect consumers from
falls in the purchasing power of their incomes, of effective real incomes and to provide
favourable conditions for investment. Banxico uses inflation targeting as a way to prevent
inflationary pressures generated by economic or external factors to achieve a stable economic
framework by means of adjustments through consistent monitoring.

Another fundamental goal of Banxico's monetary policy is to control inflation and financial
stability. Efforts to monitor and limit risks on Mexico’s financial system in order to avoid
disruptions that might harm the economy as a whole. Banxico routinely watches over the
financial markets, evaluates the soundness of financial institutions, and takes any regulatory
measure required to guarantee the integrity of the system in response to systemic risks. Thus,
financial institutions are given liquidity by providing liquidity to financial institutions to cover
liquidity shortages or prevent financial distress. Banxico’s commitment to financial stability also
includes being alert to possible vulnerabilities in the financial system, including those that may
arise from world market fluctuations, fluctuations in investor sentiment or changes in domestic
policies. Banxico’s job is to ensure the resilience of the financial system, thereby not only
increasing the confidence of businesses, investors and the general public in the stability of
Mexico’s economy, but also reducing the costs of financial system shocks.

The goals of inflation targeting and neutral financial stability are cited by interdependence
between price stability and a shilled financial system and by a stable financial system to inflation
targeting. Focused on these goals, Banxico helps to establish a supportive foundation for
sustained economic growth by assuring stable inflation, thereby promoting consumption and
investment and effectively safeguarding both domestic and foreign investors through a healthy
financial system. In addition, these goals are consistent with the best practices internationally, as
Banxico advances transparency and accountability in its monetary policy decisions.

The shape of Banxico’s dual approach signals its role as an economic stabilising force, applying
policy measures to weather emerging economic challenges and external shocks while
maintaining long-term economic stability. Banxico constantly checks inflation targeting and
financial stability to strengthen the country's economic resilience and to create a more
predictable environment than what would allow Mexico's development goals to be achieved with
greater effectiveness.
The Bank of Mexico: Tools and Strategies
The Bank of Mexico (Banxico) uses a variety of monetary tools and strategies to ensure the
country’s economic stability, control inflation, and maintain financial stability. Its instruments of
choice, interest rates, foreign exchange interventions, and reserve requirements are used
primarily by Banxico to achieve its objectives and maintain Mexico's strong economic health.

Interest Rates: The benchmark interest rate, or target of the overnight interbank interest rate, is
Banxico’s main policy instrument. Banxico controls the rate at which this happens, and this
affects borrowing and lending across the economy. High inflationary pressures cause Banxico to
raise the benchmark to make borrowing more costly, slowing spending and investment and
increasing the cost of borrowing in turn. If, instead, economic growth is slow, Banxico will
lower interest rates to stimulate spending and investment. Banxico makes these adjustments to
help balance inflation control with economic growth so the economy is running smoothly within
the inflation targets.

Foreign Exchange Interventions: Mexico uses a floating exchange rate system but Banxico
intervenes on occasions when the peso goes too far outside normal bands of volatility. The
interventions are not intended to help stabilise the peso value but instead to curb large swings of
the peso that might harm the economy. In addition, Banxico can sell or buy foreign currency to
keep a peso more or less stable so it doesn’t depreciate or appreciate quickly. The peso's
movement is normally used for such actions when it can hurt financial stability and erode
inflation expectations or public confidence. In doing so, Banxico can calm markets, provide
liquidity restore confidence in the peso, and also sustain stability.

Reserve Requirements: Even though reserve requirements are not Banxico’s principal tool of
regulation, they do contribute to the banking system’s liquidity. Banxico controls the amount of
funds that banks have to hold, rather than lend, by setting minimum reserve requirements. A
bank’s reserve requirements act as higher reserve requirements that restrict the amount of money
in the public’s circulation. Lowering these requirements puts more money into the banking
system, funding lending and helping fuel economic activity. They are not used as often as they
are interest rates. Hence, adjusting reserve requirements allows Banxico to influence the money
supply and influence its inflation and financial stability goals indirectly.
Open Market Operations (OMOs): Through a large apparatus of operations known as open
market operations (OMOs), Banxico controls the money supply and short-term interest rates,
buying and selling government securities. When they buy securities Banxico puts liquidity into
the banking system and encourages lending and spending that can stimulate the economy. On the
other hand, when it sells securities, it cuts liquidity and cools an overheated economy, as it is
done to rein in inflation. For Banxico, OMOs are flexible and effective instruments for the
precise adjustment of the money supply and to bring the economy closer to its policy targets.

Inflation Targeting Communication: In addition, Banxico releases its inflation targets and
policy decisions to the public to manage expectations. Banxico wants to build confidence and
transparency into its policies by openly stating its inflation targets and explaining how it is going
to achieve them. This communication is a 'soft tool'. It influences economic behaviour and
reinforces its credibility to achieve price stability.

Banxico supports Mexico’s inflation targets and overall financial stability through interest rate
adjustments, foreign exchange interventions, reserve requirements, open market operations and
transparent communication. This multiform approach allows Banxico to respond efficiently to
different economic stresses and adapt the tools to maintain a stable economic environment.
The Mexican Peso Crisis: The Causes and Implications for
Policymakers
The crisis associated with Mexico, most widely known as the Mexican peso crisis of 1994-1995,
was a severe financial crisis initiated by the consequences of internal and external actions and
ended with the desperate devaluation of the peso. The crisis affected Mexico in a very significant
way and, at the same time, provided authorities with important lessons.

Causes of the Crisis

The Mexican peso crisis stemmed from several key factors, including a fixed exchange rate,
reliance on short-term capital, fiscal deficits, and policy missteps that collectively weakened the
economy and undermined investor confidence.

1. Fixed Exchange Rate and Currency Overvaluation: The fixed exchange rate policy which
Mexico had adopted was one of the major causes of the peso crisis. When manipulating the
exchange rate, Mexico sought to make the peso equal to the dollar, hence enabling a check on
inflation rates in the economy. Nevertheless, as the years wore on, it became realised that the
peso had become out of the ideal range. Consequently, Mexican exports were beginning to
become expensive while imports were getting cheaper, thus increasing the trade imbalance. The
overvaluation of the peso led to the emergence of an unsustainable balance of payments. It soon
caused the emergence of doubts concerning the capacity of the country to maintain the fixed rate.

2. High Reliance on Short-Term Capital Inflows: In the early 1990s, Mexico received a large
amount of FDI, mainly in the form of portable investment, that is, portfolio investment, as
opposed to FDI investment. These were risky investments, and whenever investors lost
confidence, there was a quick pullout. These short-term capital inflows upon which the
government relied so much were volatile, and the overdependence led to an increase in capital
flight, thus deepening the crisis.

3. Increasing Fiscal Deficit and Political Instability: Mexico was keen on cutting the fiscal
deficit. However, the government was still under financial pressure. Economic Liberalization
was, however, rolled back by political events, including the Zapatista uprising in Chiapas and the
assassination of presidential candidate Luis Donaldo Colosio. These events created doubt and
made investors sceptical about Mexico's political and economic stability. Interference from the
external world, such as fiscal pressures and political instability, led to output deterioration and
capital flight, hence the depreciation of the peso.

4. Inadequate Foreign Reserves and Policy Missteps: Mexico needed help to adequately
defend the peso as investors began to try to trade their pesos for dollars. In December 1994, the
Mexican government declared devaluation in a limited manner, aiming to reduce the pressure on
its reserves. However, this action frightened investors and caused a complete currency crisis
because the peso’s value fell sharply. The government, once again, was unprepared, and it did
not have adequate reserves to prop up the currency peg any further.

Key Lessons for Policymakers

The Mexican peso crisis of 1994-1995 provides lessons for policymakers on how to improve
economic stability, control external shocks, and protect financial systems against crises.

1. Flexible Exchange Rate Systems Reduce Vulnerability: In fact, one of the important policy
implications that one can learn from the peso crisis is that a fixed exchange rate system poses
certain dangers. A floating rate means that the currency follows the relative fluctuation of other
currencies, so it is not easily overvalued or subject to a sudden devaluation and capital flight.
Since independence, many countries have started adopting floating exchange rate mechanisms as
this is more effective in managing external shocks and conforms to the realities of the market
much more comfortably.

2. Diversification of Foreign Investment: It is associated with the vulnerability of a country to

short-term capital volatility in the event that investors change their minds and pull out their
money. This policy was learned by policymakers in Mexico and other countries where the
sudden pulling out of investments is preferred, and instead, they focused on stable investments
such as FDI. This approach also aids in avoiding vulnerable economy profiles for capital flowing
and enhancing a more secure economy characteristic.

3. Robust Foreign Exchange Reserves Are Crucial: The Mexican peso crisis pointed out the
need for sufficient foreign exchange reserves to protect the country’s currency against vulture
attacks. Governments have become more careful while controlling reserves especially those that
have fixed or managed foreign exchange rates. Sufficient stocks give support, which may be
used to stabilise the currency and ensure public confidence is maintained among investors.

4. Sound Economic Policies and Transparency Build Confidence: Investor’s panic during the
peso crisis was caused by political instability and the absence of information regarding
government plans. Policymakers have realised that, for confidence to be built and sustained,
economic policies must be communicated well and openly. Goals and rules for fiscal and
monetary management and their communication play an important role in calming markets in
case of volatility.

5. Prudence in Borrowing and Sustainable Fiscal Policies: Mexico’s experience pointed to the
fact that for the country to run efficiently, it requires to practice of prudent fiscal policies and
also the consequence of borrowing in foreign currency. Now, countries cannot afford to borrow
foreign currency without having adequate foreign income to support it, for it leads to the
emergence of vulnerabilities due to the devaluation of currency. Modern politicians pay attention
to the issue of reasonable debt levels and adherence to fiscal responsibility in order to avoid
the negative impacts of global volatility.