Question

Explain why the U.S. demand for Mexican pesos slopes downward and the supply of pesos to Americans slopes upward. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following will cause the Mexican peso to appreciate or depreciate, other things equal:

a. The United States unilaterally reduces tariffs on Mexican products.

b. Mexico encounters severe inflation.

c. Deteriorating political relations reduce American tourism in Mexico.

d. The U.S. economy moves into a severe recession.

e. The United States engages in a high-interest-rate monetary policy.

f. Mexican products become more fashionable to U.S. consumers.

g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.

h. The rate of productivity growth in the United States diminishes sharply.

Short answer

A decrease in demand for pesos decreases the dollar price of the peso, the peso depreciates, and vice-versa. Hence, the demand curve of the peso is downward sloping.

An increase in supply for pesos decreases the dollar price of the peso, the peso depreciates, and vice-versa. Hence, the supply curve of the peso is upward sloping.

1. Peso will appreciate.

2. Peso will depreciate.

3. Peso will depreciate.

4. Peso will depreciate.

5. Peso will depreciate.

6. Peso will appreciate.

7. Peso will appreciate.

8. Peso will appreciate.

Step-by-step solution

Slopes of supply and demand

The question can be answered by taking an example. Suppose a U.S. citizen needs only 0.5 dollars to buy 1 peso; they will end up wanting to purchase many more pesos than if it costs $1.50 to buy 1 peso. The lower the dollar price of buying a peso, the less expensive Mexican goods, and services appear to an American. So they can sell more dollars for pesos to buy “cheap” Mexican products. So, the demand curve for pounds slopes downward.

The supply-of-peso curve slopes upward because the Mexican will purchase more U.S. goods as the dollar price of a peso rises (that is, as the pound price of a dollar falls). The more dollars the Mexicans can get in exchange for 1 peso, the less expensive U.S. products will look to them and, hence, the more pesos they will want to supply to get the dollars they need to purchase “cheap” U.S. products.

The intersection of the supply curve and the demand curve determine the dollar price of pounds.

Volatility in the flexible exchange rate

Determinants of flexible exchange rates include (a) changes in tastes; (b) relative national incomes; (c) relative inflation rates; (d) real interest rates; (e) relative expected returns on stocks, real estate, and production facilities; and (f) speculation.

a. The United States unilaterally reduces tariffs on Mexican products: the export of Mexican products will increase due to the reduction of tariffs by the U.S. government. American’s demand for pesos in the FOREX market increases; hence peso appreciates.

b. Mexico encounters severe inflation: Mexicans will purchase relatively low-priced goods in the U.S. The demand for dollars increases, resulting in the peso depreciating.

c. Deteriorating political relations reduce American tourism in Mexico: Reduction in tourism in Mexico will reduce demand for pesos (by Americans); thereby, the peso depreciates.

d. The U.S. economy moves into a severe recession: Income of Americans will reduce during the recession due to which demand for pesos falls. The peso will depreciate.

e. The United States engages in a high-interest-rate monetary policy: The high-interest rate will attract loans for Americans, and Mexicans will purchase more bonds. Mexicans will supply peso to the FOREX market. A surge in supply will depreciate the peso.

f. Mexican products become more fashionable to U.S. consumers: U.S. demand for Mexican products will increase demands for pesos, the peso will appreciate.

g. The Mexican government encourages U.S. firms to invest in Mexican oil fields: Purchasing or sharing in Mexican oil fields will increase the demand for pesos at the FOREX market. The peso will appreciate.

h. The rate of productivity growth in the United States diminishes sharply: The diminishing productivity growth means low export and high import. The increase in imports will increase the demand for pesos, the peso will appreciate.