Question

Suppose a new study reveals major health benefits from the consumption of avocados, of which Mexico is the world’s largest producer. As a result of the study, U.S. citizens start eating more avocados. Using a model of exchange rates, explain and illustrate the effect of this change in consumer preferences on both Mexican pesos and U.S. dollar markets.

Please draw graph

Answer 1

US citizens consuming more avocados will increase US import demand from Mexico, which will increase the demand for peso and increase the supply of US dollar (since US will sell dollars and buy peso in order to pay for Mexican goods).

In each of the following graphs, D0 and S0 are initial demand and supply curves of the currency, intersecting at point A with initial exchange rate P0 and quantity of currency Q0.

(i) Market for Peso

Higher demand for peso will shift its demand curve to right, increasing exchange rate (i.e. peso appreciates) and increasing quantity of pesos traded. In following graph, D0 will shift rightward to D1, intersecting S0 at point B with higher peso exchange rate P1 and higher quantity of peso Q1.

(ii) Market for US dollar

Higher supply of dollar will shift dollar supply curve rightward. This will decrease US exchange rate and increase quantity of dollar, causing dollar to depreciate. In following graph, S0 will shift rightward to S1, intersecting D0 at point B with lower US exchange rate P1 and higher quantity of dollar Q1.