Macro doubt

[Arushi]

Assume that the market for Mexican pesos begin in equilibrium.  Then, the Mexican economy experiences a severe recession.  Because of the recession, the Mexican companies lower their prices. As a result of the recession and lower prices in Mexico:
    a.  the dollar depreciates and the peso appreciates
    b.  the dollar appreciates and the peso depreciates
    c.  the dollar and the peso both appreciate
    d.  the dollar and the peso both depreciate

Please also explain the logic of the answer.

[ViV]

B

[kangkan]

Real exchange rate (of pesos)= Cost of mexican basket/cost of US basket..here cost of mexican basket goes down..hence the peso will depreciate in real terms

[Ashima]

But kangkan, with cost of basket for mexican goods decreasing, real exchange rate is decreasing, so shouldn't peso appreciate? I am getting a bit confused

[Dreyfus]

If we use absolute PPP ....price in mexico = price in us*E(peso/$)
And when price in mexico↓ this means either price in us must fall or E(peso/$) must fall or both....dat means $ will depreciate ....

[The Villain]

I think the answer is a

[Akshay Jain]

Acc. To me...think this in terms of relative ppp dat is
domestic currency depriciation (%) is equal to domestic Inflation  minus foreign inflation....

[Dreyfus]

Or if we think  another way....when price in mexico falls their will be arbitrage possibility b/w mexico and us..... arbitrageurs will buy from mexico in pesos via forex by exchanging dollars for pesos leading to higher demand for pesos higher supply for dollars in forex market ....thus peso will app....

[ashutosh]

I think the answer has to be b. (if we think in terms of real exchange rate)
Bcoz e= E P*/P
Since P is falling, real interest rate must depreciate.

@vaibhav.  I dnt think that there can be any arbitrage possibility. You will need 3 markets for that.

[Dreyfus]

@ashutosh .... whether its an exchange rate or an interest rate....the real quantities r always set by households , it is only nominal quantities that are set by/in authorities or markets, since either of the options doesn't have "real" term ....dat means it is talking in nominal terms I.e. that specified in market due to demand and supply factor....

[Ditro Raychaudhuri]

its A surely 

[Homer Simpson]

I think its (a)

[ashutosh]

a wil be in case we are assuming real exchange rate to be constant.

[kangkan]

yes..i too think peso will appreciate

[Arushi]

Could you plz explain how you arrived at the answer?

[Ditro Raychaudhuri]

When the Mexican companies  reduce prices their goods become relatively cheaper than the American counterparts and hence Americans would more likely buy Mexican goods than their  domestic ones.
The demand for Mexican goods rises and hence to buy them Pesos are demanded. Therefor the pesos APPRECIATE due to foreign demand  for the currency. The dollar is sold by the Americans ( to buy pesos) so its demand falls and hence it DEPRECIATES.
This is my logic may be wrong.

[ViV]

Guyz! coming to the conclusion read the question again..
the Mexican economy experiences a severe recession.  Because of the recession, the Mexican companies lower their prices.

Do you think the price is for goods and commodities?
In recession do you think prices of goods and commodities fall?

In recession people are unemployed, production goes down. Then how this is possible that goods are cheaper in Mexican country than US?

So answer is the (b) which I earlier posted.

[Ditro Raychaudhuri]

yes actually recession used to be deflationery in nature nowadays dere is stagflation during recession

[kangkan]

@arushi..this is how i arrived at the answer

Assuming that relative ppp holds we know that  delta Ep/$/Epeso/$= inflation in argentina- inflation in us

Now inflation in argentina is negative and in US it its zero therefore delta Epeso/$ must be negative..hence the pesos will aprreciate since i will get fwer peso for every dollar...

[Homer Simpson]

how to do these???