Question

"Suppose Mexico wants to fix its exchange rate relative to the US dollar. Suppose now the Fed raises interest rates. If initially there is not a response in Mexican interest rates, what will happen initially to the nominal mexican peso (MXN) - dollar (USD) exchange rate?"

		"US bonds become less attractive, relative to Mexican bonds, therefore there will be an increase in demand for Mexican bonds and Mexican currency. The Mexican Central Bank (Banco de México) will buy USD at the fixed exchange rate to maintain it."
		"US bonds become more attractive, relative to Mexican bonds, therefore there will be an increase in demand for US bonds and US currency. The Mexican Central Bank (Banco de México) will sell USD at the fixed exchange rate to maintain it."
		"US bonds become less attractive, relative to Mexican bonds, therefore there will be an increase in demand for Mexican bonds and Mexican currency. The Mexican Central Bank (Banco de México) will sell USD at the fixed exchange rate to maintain it."
		"US bonds become more attractive, relative to Mexican bonds, therefore there will be an increase in demand for US bonds and US currency. The Mexican Central Bank (Banco de México) will buy USD at the fixed exchange rate to maintain it."

Answer 1

Correct option: (b) US bonds become more attractive...The Mexican central bank will sell USD at the fixed exchange rate to maintain it

Reason: An Increase in interest rates in US will make return on US bonds more, thereby Increasing the demand for US bonds. Mexican investors will start investing more dollars to invest in US. Since the government would want to maintain a fixed exchange rate, they will start selling USD at the current exchange rate to bring up the value of Mexican currency and thus make the exchange rate fixed again.