Mexican interest rates are normally substantially higher than U.S. interest rates.
a. What does this imply about the inflation differential (Mexico inflation minus U.S. inflation), assuming that the peso interest rate is the same in both countries? Does this imply that the Mexican peso will appreciate or depreciate? Explain.
b. It may be argued that the high Mexican interest rate should entice U.S. investors to invest in Mexican money market securities, which could cause the peso to appreciate. Reconcile this theory with your answer (a). If you believe that the high Mexican interest rate does not entice U.S. investors, explain why.
c. Assume that the difference between Mexican and U.S. interest rates is typically attributed to a difference in expected inflation in the two countries. Also assume that purchasing power parity holds. Do you think that your business cash flows would be adversely affected? In reality, purchasing power parity does not hold consistently. Assume that the inflation differential (Mexico inflation minus U.S. inflation) is not fully offset by the exchange rate movement of the peso. Would this benefit or hurt your business? Now assume that the inflation differential is more than offset by the exchange rate movement of the peso. Would this benefit or hurt your business?
d. Assume that the nominal interest rate in Mexico is presently much higher than the interest rate in the U.S., which is due to a high rate of expected inflation in Mexico. You consider implementing a marketing campaign in which you would hire a local firm to promote your business, but you would have to borrow funds to finance this campaign. A consultant advises you to delay the marketing campaign for a year, so that you can capitalize on the high nominal interest rate in Mexico. He suggests that you retain the profits that you would normally have remitted to the U.S., and deposit them in a Mexican bank. The Mexican peso cash flows that your business deposits will grow at a high rate of interest over the year. Should you follow the advice of the consultant?