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

The contractionary monetary policy shifts the LM curve leftward by reducing money supply. As a result, exchange rate increases. To keep exchange rate fixed at its pegged level, central bank must sell domestic currency. This will increase money supply, shifting LM curve rightward to its initial position, without affecting initial exchange rate or output.

In following graph the Mundell-Fleming Open economy IS-LM model is depicted. IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial exchange rate e0 and initial output Y0. When LM0 shifts left to LM1, it intersects IS0 at point B with higher exchange rate e1 and lower output Y1. Central bank's intervention shifts LM1 rightward to LM0, restoring initial equilibrium at point A. So, in open economy model, monetary policy doesn't affect output or exchange rate in Fixed exchange rate regime.

e LM LMO ei B A IS, Y Yo Y