Question

If the FED wanted to offset a large depreciation of the dollar against the Mexican peso, what policy could the FED take to achieve this objective (do not forget to discuss the role of FED’s balance sheet in the your answer).

Answer 1

Dollar would depreciate against the Mexican peso, if there was less demand for the dollar as compared to the peso. Thus to offset the depreciation the Fed would increase the demand for the dollar by buying the dollar, thereby leading to short supply of the dollar in the market and sell the Mexican peso which would increase the supply in the market as compared to the demand. Thus it will use direct intervention in the foreign market.

It will alter the currency composition of Fed's balance sheet but it does not significantly change the size of the monetary base.