Part 1: Mexico and the United States are trade partners. Each country has a zero current account balance and is operating in long-run equilibrium. Assume that the inflation rate in the United States is slowing relative to Mexico's inflation rate.

(a) How will the inflation rate change in the United States affect:

Mexico's demand for U.S. goods and services?

net exports of Mexico? Explain.

(b) Illustrate the impact of the change you identified in part (a) on a fully labeled AD-AS model for the economy of Mexico. Use arrows to indicate any changes in AD, real GDP, and price level.

(c) Ceteris paribus, will the national income of the United States increase, decrease, or remain the same?

(d) On side-by-side and fully labeled foreign exchange market graphs, illustrate the impact of the change in relative inflation on the supply of Mexican pesos and on demand for U.S. dollars. Use arrows to indicate the change in the equilibrium exchange rate for each currency.