Question: Fixed versus floating exchange rates:

(a) When the Federal Reserve raises interest rates, U.S. assets become more attractive than Mexican assets. This increases the demand for dollars and reduces the demand for pesos, putting pressure on the peso to depreciate.

(b) In this hypothetical example, Mexico is attempting to violate the policy trilemma - trying to achieve all three goals simultaneously. At the old exchange rate, investors will want to trade their pesos for dollars to take advantage of the high U.S. interest rate. The Mexican central bank can finance these exchanges using its foreign reserves, but eventually Mexico will run out of dollars. As it runs out of dollars, it will be forced to reduce the value of the peso so as to stem the demand for these exchanges.

(c) This example helps us to think about why all three goals of the policy trilemma cannot be achieved simultaneously, at least in the long run. It also shows how in the short run, a country may appear to be meeting all three goals if it is running down its supply of foreign reserves. This actually happened in Mexico in 1994.