Question

Suppose Mexico wishes to fix its exchange rate relative to the US dollar. If the Federal Reserve raises interest rates, what would happen to the peso-dollar exchange rate in the absence of any change in Mexican interest rates?

Answer 1

In this scenario, if the Fed raises the interest rates, the demand for U.S. dollars will rise, because investment in U.S. dollars will now be cheaper. This will in turn lower the demand for Mexican Pesos, putting pressure on the Mexican currency to depreciate (to lose value against the U.S. dollar).