Question

The Monetary Approach to Exchange Rates In this question, assume the more general model where L depends on the interest rate. Consider a world in which the prices of goods are perfectly flexible and absolute PPP holds. This world has two countries, the U.S. and Mexico. The real interest rate is equal to 1% and it is fixed on world markets. Suppose the money growth rate is 3% in the United States and 4% in Mexico. Real GDP is growing at a 1% rate in Mexico and in the United States.

a. Now suppose that at time T, Mexico’s expected GDP growth rates falls to 0. What is the effect of the shock on the Mexican nominal interest rate, price level, and Mexican peso exchange rate at time T?

Answer 1

If the expected GDP growth rate falls that means that there is a bearish sentiment in the Mexican market and the consumers have a pessimistic outlook with regards to the economic climate. We know that the monetary approach dictates that the demand for money is the direct function of real income and price levels. Therefore with the advent of growth rates nearing 0, the real incomes of the Mexican people are likely to drop and therefore the demand for money is also likely to dip as well. With the drop in real income, the expected consumption expenditure is likely to take a hit, which will cause the price levels to stagnate or in an extreme case even drop.

In order to increase the demand for money and make interest-sensitive investments and purchases attractive, the Mexican central bank is like to adopt an expansionary monetary policy and drop the interest rates to boost economic growth. An increase in the supply of money in Mexico will cause the exchange rate to rise. In other words, the peso will lose value against the dollar and more pesos will be needed to exchange it for one dollar.