Question

Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following would 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

The Mexican peso appreciates in scenarios a, f, g, and h, and depreciates in scenarios b, c, d, and e.

Step-by-step solution

Understanding U.S. Demand for Pesos

The U.S. demand for Mexican pesos is downward sloping because as the exchange rate (price of pesos in terms of dollars) decreases, it becomes cheaper for Americans to buy Mexican goods and services, leading to increased demand for pesos. This is because American consumers and businesses require more pesos to make these purchases.

Understanding Supply of Pesos

The supply of pesos to Americans is upward sloping because as the exchange rate increases, it becomes more profitable for Mexicans to sell their goods and services to the United States or invest there, as they get more dollars for each peso. This incentivizes Mexicans to supply more pesos to the foreign exchange market.

Analyzing Impact of Reducing Tariffs

a. If the United States unilaterally reduces tariffs on Mexican products, it becomes cheaper for Americans to import Mexican goods, increasing the demand for pesos to pay for these imports. As a result, the peso would appreciate.

Impact of Inflation in Mexico

b. If Mexico encounters severe inflation, Mexican goods become relatively more expensive, reducing U.S. demand for these goods. Consequently, the demand for pesos decreases, causing the peso to depreciate.

Impact of Decreasing American Tourism

c. If deteriorating political relations reduce American tourism in Mexico, fewer dollars are converted to pesos, decreasing the demand for pesos, leading to depreciation of the peso.

Impact of U.S. Recession

d. If the U.S. economy moves into a severe recession, Americans will likely decrease spending on imports, including Mexican goods, reducing the demand for pesos. Thus, the peso would depreciate.

Impact of High-Interest U.S. Policy

e. If the United States engages in a high-interest-rate monetary policy, it attracts foreign investment, including from Mexicans, increasing the demand for dollars. Thus, the supply of pesos to the market increases, causing the peso to depreciate.

Fashionable Mexican Products

f. If Mexican products become more fashionable to U.S. consumers, demand for these products increases. Consequently, the demand for pesos increases, leading to appreciation of the peso.

Investment in Mexican Oil Fields

g. If the Mexican government encourages U.S. firms to invest in Mexican oil fields, there is an increase in demand for pesos as U.S. firms convert dollars to pesos for their investments. This causes the peso to appreciate.

Decreasing U.S. Productivity Growth

h. If the rate of productivity growth in the United States diminishes sharply, U.S. goods and services become relatively less competitive compared to Mexican goods, increasing the demand for Mexican products and, subsequently, pesos. This situation leads to appreciation of the peso.

Key concepts

Exchange Rates

Exchange rates are like the price tags for currencies from different countries. They tell you how much one currency is worth in terms of another. Imagine going on vacation to another country. You'd need to exchange your local money for the money used in that country. The rate you get tells you how much foreign currency you'll receive for every unit of your home currency.
Exchange rates can be influenced by many things, including demand and supply dynamics in the foreign exchange market. When people want more of a currency, maybe because the products or services from that country are appealing, the demand increases. The higher the demand for a currency, the more it usually costs, leading to its appreciation. Conversely, if fewer people want a currency, its value may fall, resulting in depreciation.

• Demand and supply of currencies interplay directly impacts exchange rates.
• Exchange rates are crucial for determining the value of international transactions.
• Some countries let market forces decide their currency's exchange rate, which is known as a flexible exchange rate system.

Currency Appreciation

Currency appreciation occurs when a currency increases in value compared to another currency. Imagine if you previously needed 20 pesos to get one U.S. dollar, but now need only 18 pesos. This means the peso has appreciated.
Several factors can lead to currency appreciation. For example, if more people want to buy a country's goods or invest in that country, the demand for its currency might increase, causing it to appreciate. Additionally, favorable economic conditions, like low inflation and strong economic growth, can also lead to currency appreciation.

• Currency appreciation means each unit of currency can buy more foreign goods.
• It attracts foreign investors since their investments in that currency gain value.
• Appreciation can make a country’s exports more expensive for foreigners.

Currency Depreciation

Currency depreciation is the opposite of appreciation. It occurs when a currency loses value compared to another currency. Imagine if you once got 18 pesos for a dollar, but now you get 20 pesos. This indicates that the peso has depreciated.
There are various reasons for currency depreciation. For instance, if a country's economy is struggling, or there is political instability, investors might move their money elsewhere, reducing demand for that currency. Sometimes, high inflation can also devalue a currency.

• Depreciation makes exports cheaper for foreign buyers.
• It boosts competitiveness for a country's products on the global market.
• However, it can also make imports more expensive, affecting local consumers.

Foreign Investment

Foreign investment involves putting money into business ventures or assets in a different country. It can be a powerful engine for economic growth, as it brings in capital and can create jobs.
When foreign investors choose to invest in a country, they usually have to exchange their home currency for the local currency, increasing demand for it. For example, if American companies invest in Mexican oil fields, they would need to buy pesos, which can lead to the peso appreciating.
Foreign investment is influenced by many factors, including the investment climate, potential for returns, and economic stability of the destination country.

• Foreign investments can lead to an increase in a country's currency demand.
• They help in boosting infrastructure and industrial capabilities of a nation.
• A country with a stable political and economic environment is often more attractive to foreign investors.