If the nominal exchange rate between the Mexican peso and the U.S

Question

dollar is fixed, and there is higher inflation in Mexico than in the United States, which currency experiences a real appreciation and which experiences a real depreciation? Why? What is likely to happen to the balance of trade between the two countries?

Answer 1

If the peso is pegged to the dollar and the rate of inflation in Mexico is greater than in the rate of inflation in the United States, the peso is appreciating in real terms and the dollar is experiencing a real depreciation. The logic is that the rate of inflation in Mexico measures the loss of internal purchasing power, while because the exchange rate is pegged, the loss of the peso's external purchasing power is measured by the U.S. rate of inflation. If a currency's loss of internal purchasing power is greater than its loss of external purchasing power, that currency experiences a real appreciation.

The real appreciation of the peso tends to make Mexican residents think that U.S. goods are relative bargains, while the real depreciation of the dollar relative to the peso, makes U.S. residents think that Mexican goods are relatively expensive. Thus, the balance of trade between Mexico and the United States on the Mexican balance of payments should deteriorate with an increase in imports from the United States and a decrease in exports to the United States.