Mexican interest rates are normally substantially higher than U.S. interest rates.

a. What does this imply about the inflation differential (Mexican inflation minus U.S.

inflation), assuming that the real interest rate is the same in both countries? Does this imply that the Mexican peso will appreciate or depreciate? Explain.

b. It might be argued that the high Mexican interest rates should entice U.S. investors to invest in Mexican money market securities, which could cause the peso to appreciate.

Reconcile this theory with your answer in part (a). If you believe that the high Mexican interest rates will not entice U.S. investors, explain your reasoning.

c. Assume that the difference between Mexican and U.S. interest rates is typically attributed to a difference in expected inflation in the two countries. Also assume that purchasing power parity holds. Do you think that your business cash flows will be adversely affected? In reality, purchasing power parity does not hold consistently. Assume that the inflation differential (Mexican inflation minus U.S. inflation) is not fully offset by the exchange rate movement of the peso. Will this benefit or hurt your business? Now assume that the inflation differential is more than offset by the exchange rate movement of the peso. Will this benefit or hurt your business?

d. Assume that the nominal interest rate in Mexico is currently much higher than the U.S. interest rate and that this difference is due to a high rate of expected inflation in Mexico. You are considering hiring a local firm to promote your business, but you would have to borrow funds to finance this marketing campaign. A consultant advises you to delay the marketing campaign for a year so that you can capitalize on the high nominal interest rate in Mexico. He suggests that you retain the profits that you would normally have remitted to the United States and deposit them in a Mexican bank. The Mexican peso cash flows that your business deposits will grow at a high rate of interest over the year. Should you follow the advice of the consultant?