Question

U.S. inflation rate: 1.2%; Mexican inflation rate: 4.5%

U.S. money growth rate: 2.2%; Mexican money growth rate: 6.4%

1. What will happen to the exchange rate between the U.S. dollar and the Mexican peso in the long run?

2. Calculate how much the Mexican peso will depreciate (or appreciate) against the U.S. dollar in the long run

Answer 1

1)

Exchange rate is affected by the inflation rate prevailing in the market. Here inflation rate in Mexico is larger than the inflation rate in USA.

Hence, Peso will depreciate relative to the dollar.

2)

Peso will depreciate equal to the inflation gap.

Inflation gap : 4.5 - 1.2

= 3.3 %

Dollar will appreciate by 3.3%