Exercise 10 In the 1970s, the Mexican government tied the exchange rate of the peso to the North American dollar. During the same period, short-term Mexican interest rates, those defined by their central bank, were significantly higher than those in the United States.

a. In this situation, what is the expectation of financial market participants in relation to the peso/dollar exchange rate in the future?

b. If financial market participants believe that probability p exists for peso depreciation, show that there is a persistent error in the forecast of the future exchange rate.

58 PRINCIPLES OF INTERNATIONAL FINANCE AND OPEN ECONOMY MACROECONOMICS