Under a flexible exchange rate system, if the equilibrium exchange rate is \(0.10 \mathrm{USD}=1 \mathrm{MXN}\) and the current exchange rate is \(0.12=1 \mathrm{MXN},\) will the U.S. dollar appreciate or depreciate? Explain.

Short Answer

Expert verified
The U.S. dollar will depreciate.

Step by step solution

01

Understanding the Exchange Rates

Recognize the equilibrium exchange rate (0.10 USD per MXN), which is the rate expected under perfect market conditions, and compare it with the current exchange rate (0.12 USD per MXN).
02

Comparing the Rates

When the current exchange rate (0.12 USD per MXN) is more than the equilibrium rate (0.10 USD per MXN), it means that the U.S. dollar is currently overvalued against the Mexican peso.
03

Evaluating Depreciation or Appreciation

Under a flexible exchange rate system, market forces tend to drive exchange rates towards their equilibrium. Therefore, since the USD is currently overvalued, we can expect it to depreciate towards the equilibrium rate.

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