Assume that the exchange rate between the U.S. dollar ($) and the Mexican peso (P) is pegged at $1/P4. Assume that, initially, this exchange rate corresponds to equilibrium in the foreign exchange market. The United States now undertakes an economic policy that puts upward pressure on the interest rate on dollar-denominated deposits. Mexico follows an economic policy that puts downward pressure on the interest rate on peso-denominated deposits.

1. If the exchange rate between the dollar and the peso had been flexible, what would have tended to happen? Why?

2. If Mexico maintains its commitment to hold the exchange rate at $1/P4, what foreign exchange operations must the Mexican central bank take?

3. Assume that the United States and Mexico continue to follow the economic policies outlined above.Suppose you are a participant in the foreign exchange market. Given your answer to (2)

3a. How might you adjust your expectation of the future dollar price of the peso ? (Hint: Mexico's foreign reserve is not unlimited.)

3b. What effect would this expectation have on the foreign exchange market?

3c. Would it make the Mexican central bank's job easier or more difficult? Why?