Question

Question 3 This question considers long-run policies in Mexico relative to Canada. Assume Mexico's money growth rate is currently 4% and its inflation rate is 2%. Canada's money growth rate is 6% with 3.25% inflation rate. The world real interest rate is 0.75%. For the following questions, use the conditions associated with the general monetary model. Treat Mexico as the home country and define the exchange rate as Mexican pesos per Canadian dollar, E/cS. a. Calculate the growth rate of real income in each country. b. Calculate the nominal interest rate in each country Calculate the expected rate of depreciation in the Mexican peso relative to the Canadian dollar. Is the peso appreciating or depreciating against the Canadian dollar? c. d. Suppose that Mexico's central bank wants to maintain a fixed exchange rate against the Canadian dollar. Assuming that nothing in Canada changes, what must the central bank do to achieve this long-run objective? What money growth rate for Mexico's money supply will make this possible? e. Calculate Mexico's new inflation rate and nominal interest rate after this policy is implemented f. Now suppose that Canada's inflation rate increases from 3.5% to 5%. If Mexico wants to maintain the fixed exchange rate, what will happen to its inflation rate?

Answer 1

a) $\pi _{M} = \mu _{M} - g_{m}$

where $\pi _{M}$ = 2% is inflation rate in Mexico, $\mu _{M}$ = 4% is growth in money supply and g_M is the growth in real output.

$g_{m} =$$\mu _{M} -$$\pi _{M}$ = 2%

Similarly, For Canada,

$g_{c} =$$\mu _{c} -$$\pi _{c}$= 6% - 3.25% = 2.75%

b) From the Fisher equation we know,

$\pi _{M} = i_{M} - r^{*}$

where $r^{*}$ is the world real interest rate.

Therefore, $i_{M} =$  $\pi _{M}$ + $r^{*}$ = 2% + 0.75% = 2.75%

Similarly,  $\pi _{C} = i_{C} - r^{*}$

$i_{C} =$  $\pi _{C}$ + $r^{*}$ = 3.25% + 0.75% = 4%

c)

The expected rate of depreciation of the Peso against the Canadian dollar is

$\pi _{M}$ - $\pi _{c}$ = 2% - 3.25% = -1.25%

The Mexican peso will appreciate against the Canadian dollar.