Suppose the United States and Mexico are each other’s sole trading partners. The Fed, afraid that the economy is about to overheat, raises the U.S. interest rate.
a. Will the dollar appreciate or depreciate against the Mexican peso? Illustrate with a diagram of the dollar–peso foreign exchange market.
b. What will happen to equilibrium GDP in the United States?
c. How would your analyses in (a) and (b) change if, at the same time that the Fed was increasing the U.S. interest rate, the Mexican central bank increased the Mexican interest rate by an equivalent amount?