Suppose that Mexico devalues the peso. What objectives would prompt the devaluation? Be specific.

Question

What will be an ideal response?

Answer 1

The objective of a devaluation is to correct a persistent overvaluation of a country’s currency. What this means in the case of the peso is that Mexico must have had a persistent balance-of-payments deficit which could not be easily corrected with offsetting transfers of official reserves. The persistence of the deficit means that Mexicans are importing more than they are exporting, that foreign investment in Mexico does not offset the current account deficit, and all of that means that Mexican goods and assets must be overvalued relative to foreign goods and services and assets. To correct this imbalance, Mexico can devalue its currency, thus making purchases of Mexican products and assets less expensive in terms of foreign currency. That is, foreigners can now get more pesos for their currency. By itself, this would increase the quantity demanded of pesos, but it should also shift the demand curve for pesos as Mexican goods are now less expensive. All of this should help correct the balance-of-payments deficit.