Check Your Understanding

1. Question

   Suppose Mexico discovers huge reserves of oil and starts exporting oil to the United States. Describe how this would affect the following:

   1. the nominal peso–U.S. dollar exchange rate

      The increased purchase of Mexican oil would cause U.S. individuals (and firms) to increase their demand for the peso. To purchase pesos, individuals would increase their supply of U.S. dollars to the foreign exchange market, causing a rightward shift in the supply curve of U.S. dollars. This would cause the nominal peso-U.S. dollar exchange rate to fall (the number of pesos per dollar would fall). The peso would appreciate and the U.S. dollar would depreciate as a result.

   2. Mexican exports of other goods and services

      With the appreciation of the peso, it would take more U.S. dollars to obtain the same quantity of Mexican pesos. If we assume that the price level (measured in Mexican pesos) of other Mexican goods and services would not change, other Mexican goods and services would become more expensive for U.S. households and firms. The dollar cost of other Mexican goods and services would rise as the peso appreciated. Thus, Mexican exports of goods and services other than oil would fall.

   3. Mexican imports of goods and services

      U.S. goods and services would become cheaper in terms of pesos, so Mexican imports of goods and services would rise.

2. Question

   Suppose a basket of goods and services that costs $100 in the United States costs 800 pesos in Mexico and the current nominal exchange rate is 10 pesos per U.S. dollar. Over the next five years, the cost of that market basket rises to $120 in the United States and to 1,200 pesos in Mexico, although the nominal exchange rate remains at 10 pesos per U.S. dollar. Calculate the following:

   1. the real exchange rate now and five years from now, if today’s price index in both countries is 100. [Reminder: Equation 15-1 provides the price index formula: (Cost of market basket in a given year/Cost of market basket in base year) × 100. For this problem, use the current year as the base year.]

      The real exchange rate equals pesos per U.S. dollar × aggregate price level in the U.S./ aggregate price level in Mexico. Today, the aggregate price level in both countries, as measured by the price index, is 100. The real exchange rate today is 10 × (100/100) = 10. The aggregate price level in 5 years in the United States will be (120/100) × 100 = 120, and in Mexico it will be (1,200/800) × 100 = 150. Thus, the real exchange rate in 5 years, assuming the nominal exchange rate does not change, will be 10 × (120/150) = 8.

   2. purchasing power parity today and five years from now

      Today, a basket of goods and services that costs $100 costs 800 pesos, so the purchasing power parity is 8 pesos per U.S. dollar. In 5 years, a basket that costs $120 will cost 1,200 pesos, so the purchasing power parity will be 10 pesos per U.S. dollar.