Question

Suppose US follows a fixed exchange rate regime. Decrease in import tariff on Mexican good by the US government will lead to of US dollar with respect to pesos, at the fixed exchange rate. To keep the exchange rate fixed, the Fed should dollars.
A. Overvaluation, buy
B. Undervaluation, sell
C. Overvaluation, sell
D. undervaluation, buy

Answer 1

Answer:

D) Undervaluation, buy

Explanation:

If the US government has a fixed exhange rate with the Mexican peso, and then, lowers tariffs on mexican goods, mexican goods will become cheaper for the American consumer, and American consumers will start to import more of them.

They will pay for those Mexican goods with US dollars that will leave the American economy, leaving the Fed with more Mexican pesos than US dollars than before.

In order to keep the exchange rate fixed, now the Fed will have to buy US dollars in the open foreign exchange market in order to reach equilibrium again.