Use the FX market diagram to answer the following question. Consider the relationship between the Mexican peso (MXN) and the Canadian dollar (CAD). Let the exchange rate be defined as Mexican pesos per Canadian dollar. For each of the following cases, illustrate the effects on the FX market and state how the following variables change: interest rates in Mexico (iMXN ) and Canada (iCAD), the spot exchange rate (EMXN/CAD), and the expected rate of return on Canadian and Mexican deposits (from the perspective of a Mexican investor). Unless otherwise noted, you may assume that the expected exchange rate is unchanged.
(a) Investors in the market anticipate an appreciation in the peso.
(b) Mexico’s interest rate decreases.
(c) Canada and Mexico decrease interest rates by the same amount.