Question

4. In late 1994 there was a political and financial crisis in Mexico. Foreign investors withdrew their funds from the country while Mexicans pulled their money out of domestic banks and switched to foreign assets. The Mexican central bank at that time maintained a fixed peso/dollar exchange rate (P/$).

a. Show on a graph the situation that the Mexican central bank faced in the foreign exchange market and explain what it was required to do.

b. Explain how the central bank’s actions affected the Mexican money supply.

c. In early 1995 the Mexican government had to abandon the fixed rate, and the peso depreciated. What would have prompted this move? d. Was the depreciation beneficial for the Mexican economy? (Hint: is there a single answer to this question?)

5. The demand and supply of foreign exchange in the Eurozone (the European countries that use the euro) are given by:

Q^D = 36 – 6 (e)

Q^S = 18 + 3 (e), where e = €/$, the price of a U.S. dollar in Euros

a. If the exchange rate is set in the foreign exchange markets, what will the exchange rate be?

b. The European Central Bank (ECB) plans to fix the exchange rate at 3 €/$. What must the ECB do to maintain the exchange rate at this level?

c. What will be the impact on the Eurozone’s money supply?

d. What could the ECB do to reverse the impact of the foreign exchange market operation?

Answer 1

4).

Consider the following fig of the “exchange rate market”, where “D1” be the initial demand for exchange rate and “S” be the supply of exchange rate and the initial equilibrium exchange rate is “E1”.

Now as the “foreign investors withdrew their funds” as well as “Mexicans pulled their money out of the domestic banks and switched to foreign assets”, => it’s a outflow of capital from “Mexico”, => the demand for “FX” will shift to “D2”, => new equilibrium “exchange rate” is “E2 > E1”, but the exchange rate is fixed at “E1”, => there is a “excess demand” of “FX”, => at “E1” there is a “BOP deficit”. So, in this case the “Mexican” government should either to “depreciate” the “exchange rate”, or “have to do something” to reduce import, => “demand for FX will shift towards the initial level, => the equilibrium exchange rate will come back to the initial level, => the situation will normal.

Now, if the central bank fix the exchange rate to the initial level, there is an excess demand of FX, => the central bank have to “sale the reserve FX” from its own reserve to meet this excess demand in exchange of money, => “money supply” decreases as the exchange rate is fixed at “E1”.

Now, in early “1995” the Mexican government abandon the fixed rate leads to depreciation of the exchange rate, => “E” will increases to “E2” the new equilibrium exchange rate. So, as the exchange rate depreciated, => the BOP came back to the equilibrium, the “FX reserve stop exhausting, the “money supply” become stable as well as the “price level”.