Question

3. 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

In following graph,

Contractionary monetary policy will increase domestic interest rate, which will increase foreign investment in Mexico. As a result, demand for peso will rise, shifting demand curve to right, increasing exchange rate and quantity of peso traded.

To reduce peso value, central bank has to sell peso and buy foreign currency such that its value falls to initial pegged rate.

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