Question

1. (a) Assume that the exchange rate between the U.S. dollar ($) and the Mexican peso (P) is pegged at ER=$1/P4. Assume that, initially, this exchange rate corresponds to equilibrium in the foreign exchange market. Illustrate the initial situation in the market for peso-denominated deposits using demand and supply curves.

(b) The United States now undertakes an economic policy that puts upward pressure on the interest rate on dollar-denominated deposits (i). Mexico follows an economic policy that puts downward pressure on the interest rate on peso-denominated deposits (i*). Explain and illustrate effects of the two countries’ policies in the foreign exchange market in the graph you draw in (a). If the exchange rate between the dollar and the peso had been flexible rather than fixed, what would happen?

(c) If Mexico maintains its commitment to hold the exchange rate at $1/P4, what actions must the Mexican central bank take? Explain.

(d) If the United States and Mexico continue to follow the economic policies outlined in part (b) above, what will happen if the Mexican central bank continues to take the action described in part (c)?

(e) Suppose you are a participant in the foreign exchange market. Given your answer to (d), how might you adjust your expectation of the future dollar price of the peso ( )? What effect would this have on the foreign exchange market? Would it make the Mexican central bank’s job easier or more difficult? Why?

Answer 1

1 Ans a.

i) The exchange rate between the U.S. dollar ($) and the Mexican peso (P) is pegged at ER=$1/P4.

ii) Mexican People will have to give up P4 to get US $1 and Us people have to give up only $0.25 to get P1. That means US dollar is strong compare to Mexican Peso.

iii) This initial equilibrium is shown in following figure.

OX Axis = Peso

OY Axis = US Dollar

DD = Demand Curve

SS =Supply Curve

E1 = Equilibrium exchange rate

Ans b)

US has an upward pressure on Interest rate that means US is offerring more or increased interest rates on dollar-denominated deposits i. e. (i)

Mexico has doward pressure on interest rate that means Mexico is giving low or decreased interest rate on peso-denominated depositsi.e. (i*).

So ( i ) < ( i*) .....(1)

Now demand for dollar-denominated deposits will increase and peso-denominated deposits will decrease as

( i ) < ( i*) from Eqn (1)

So

( Demand for peso-denominated deposits will decrease)

New equilibrium Point = E2 where Supply =demand i. e. SS= D1D1

If the exchange rate between the dollar and the peso had been flexible then

(Supply for US dollar will increase as its demand will increase)

And equilibrium will be established at point E3 where Supply = Demand i.e. S1S1 = D1D1

Ans c) If Mexico maintains its commitment to hold the exchange rate at $1/P4

Mexican central bank will adapt various tools to maintain this exchange rate.

i) It will try to maintain this exchage rates by increasing interest rate for  peso-denominated deposits. So that capital movemnet from Mexico to US will decrease and exchange rate will be maintained.

ii) Bank will try to mantain price level as rise in prices will decrease the demand for Mexican goods and increase the demand for US goods.

iii) And ultimately cause the change in exchange rate. Therfore Mexican central bank will try to maintain the existing price level by decreasing interest rate on loans by increasing CRR and SLR to control the inflation

iv) Central bank will raise the bank rate so more funds will flow into the country and from abroad and earn the high interest rate. It will tend to raise the demand for domestic currency and exchange rate will move in the favour of the country.

Ans d

If Mexico maintains its commitment to hold the exchange rate at $1/P4, Exchange rate will float somewhere between Point E1 and E2 shown in figure. as both of the countries are trying to manitain or increase the exchage rate by aprrreciating their currencies by applying various policies to control foreign exchange rate.