Question

Under a flexible exchange rate system, if the equilibrium exchange rate is \(0.10 \mathrm{USD}=1 \mathrm{MXN}\) and the current exchange rate is \(0.12=1 \mathrm{MXN},\) will the U.S. dollar appreciate or depreciate? Explain.

Short answer

The U.S. dollar will depreciate.

Step-by-step solution

Understanding the Exchange Rates

Recognize the equilibrium exchange rate (0.10 USD per MXN), which is the rate expected under perfect market conditions, and compare it with the current exchange rate (0.12 USD per MXN).

Comparing the Rates

When the current exchange rate (0.12 USD per MXN) is more than the equilibrium rate (0.10 USD per MXN), it means that the U.S. dollar is currently overvalued against the Mexican peso.

Evaluating Depreciation or Appreciation

Under a flexible exchange rate system, market forces tend to drive exchange rates towards their equilibrium. Therefore, since the USD is currently overvalued, we can expect it to depreciate towards the equilibrium rate.

Key concepts

Understanding the Flexible Exchange Rate System

In a flexible exchange rate system, the value of a currency is determined by market forces without direct government or central bank interventions. This means exchange rates fluctuate based on supply and demand in the global market. As demand for a currency rises, its value increases, leading to appreciation. Conversely, if demand falls, the currency depreciates.

This system is characterized by its responsiveness to economic conditions. For example, if a country has a strong economic outlook, investors might increase demand for its currency, causing it to appreciate. Conversely, economic instability can lead to depreciation.

• Responsive to market forces
• Reacts to economic indicators
• No government or central bank control

Understanding how a flexible system operates is essential for predicting currency movements effectively.

Currency Appreciation and Depreciation

Currency appreciation occurs when a currency's value increases relative to another. This means that you can buy more of a foreign currency with the same amount of your own currency. On the other hand, currency depreciation is when a currency's value decreases, making it cheaper against foreign currencies.

In our context, if the USD is overvalued at the rate of 0.12 USD per MXN when the equilibrium is at 0.10 USD per MXN, the natural market tendency would lead to depreciation. The USD would likely fall towards the equilibrium rate as more people sell USD to gain from the higher valuation.

• Appreciation: Currency value rises
• Depreciation: Currency value falls
• Market forces drive changes in value

As exchange rates change, they impact international trade, investments, and even daily expenses for consumers.

Equilibrium Exchange Rate Explained

The equilibrium exchange rate is where the demand and supply for a currency in the foreign exchange market are equal. In simpler terms, it is the exchange rate at which the market "clears," with no shortage or surplus of the currency.

This rate is significant because it represents a stable market condition where currencies trade at their true economic values. If the current exchange rate deviates from this, as in the exercise (0.12 USD per MXN vs. the equilibrium 0.10 USD per MXN), market forces will often cause rates to move toward equilibrium.

• The balance of currency demand and supply
• Signals a stable exchange environment
• Predicts currency movement trends

Understanding the concept of equilibrium helps in analyzing potential currency trends and making informed economic decisions.