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In: Economics

6. Suppose two countries, Mexico and Peru, trade freely and allow investments to flow across their...

6. Suppose two countries, Mexico and Peru, trade freely and allow investments to flow across their borders as well. Draw two graphs: one for the supply and demand for Mexico’s currency and one of supply and demand for Peru’s currency. Be sure to label the axes of your graphs. Show how the value of each currency will be affected if the interest rate on investments in Mexico rises while the return on investments in Peru remains unchanged.

Solutions

Expert Solution

6.

In the graph below, DD is intial demand for Peso(Mexican currency) and SS is the supply of Peso. E0 is the initial exchange rate in terms of Sol per Peso(Peru's currency) and Q0 is the initial quantity of Peso. Now as the inierest rate on investment in Mexico increases it cause people to invest more in Mexico which result into more demand for Peso. This will cause rightward shift of DD to DD'. The new equilibrium exchange rate is E1 which is higher than earlier which means the Value of Peso rise or appreciated.

In the graph below, DD is intial demand for Sol and SS is the supply of Sol. E0' is the initial exchange rate in terms of Peso per Sol(Peru's currency) and Q0' is the initial quantity of Sol. Now as the interest rate on investment in Mexico increases it cause people to invest more in Mexico which result into demand for Sol to fall. This will cause leftward shift of DD to DD'. The new equilibrium exchange rate is E1' which is Lower than earlier which means the Value of Sol decreases or depreciated.

Rahul Sunny answered 1 year ago
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