Assume the Federal Reserve believes that the dollar should be weakened against the Mexican peso. Explain how the Fed could use direct and indirect intervention to weaken the dollar’s value with respect to the peso. Assume that future inflation in the United States is expected to be low, regardless of the Fed’s actions.
The Fed could use direct intervention by selling some of its dollar reserves in exchange for pesos in the foreign exchange market. It could also use indirect intervention by attempting to reduce U.S. interest rates through monetary policy. Specifically, it could increase the U.S. money supply, which places downward pressure on U.S. interest rates (assuming that inflationary expectations do not change). The lower U.S. interest rates should discourage foreign investment in the United States and encourage increased investment by U.S. investors in foreign securities. Both forces tend to weaken the dollar’s value.