Question

Suppose Mexican central bank chooses to peg the peso to the US dollar and commits to a fixed exchange rate of $0.05 per peso (par value). Use a graph of dollar-peso foreign exchange market (you can put dollars per peso on the vertical axis) to show what happens when the Fed pursues contractionary monetary policy. Will peso become overvalued or undervalued? What kind of intervention should Mexican central bank employ to defend the peg?

Answer 1

Contractionary monetary policy decreases money supply and increases Mexican interest rate, thus increasing foreign investment in Mexico. Hence,demand for peso will increase, shifting its demand curve to right, increasing exchange rate and quantity of peso.

To decrease value of peso to its pegged (lower) rate, central bank should sell peso and buy foreign currency. Higher supply of peso will decrease its exchange rate.

In following graph, exchange rate (P) and quantity of Peso (Q) are depicted at vertical and horizontal axis, respectively. D0 and S0 are initial demand and supply curves of Peso, intersecting at point A with initial exchange rate P0 and quantity of Peso Q0. When demand is higher, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of peso Q1.