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The puzzling peso

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  • Carlos Arteta
  • Steven B. Kamin
  • Justin Vitanza
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    Abstract

    In the past decade, some observers have noted an unusual aspect of the Mexican peso's behavior: During periods when the U.S. dollar has risen (fallen) against other major currencies such as the euro, the peso has risen (fallen) against the dollar. Very few other currencies display this behavior. In this paper, we attempt to explain the unusual pattern of the peso's correlation with the dollar by developing some general empirical models of exchange rate correlations. Based on a study of 29 currencies, we find that most of the cross-country variation in exchange rate correlations with the dollar and the euro can be explained by just a few variables. First, a country's currency is more likely to rise against the dollar as the dollar rises against the euro, the closer it is to the United States and the farther it is from the euro area. In this result, distance likely proxies for the role of economic integration in affecting exchange rate correlations. Second, and perhaps more surprisingly, a country's currency is more likely to exhibit this unusual pattern when its sovereign credit rating is more risky. This may reflect that currencies of riskier countries are less substitutable in investor portfolios than those of better-rated countries. All told, these factors well explain the peso's unusual behavior, as Mexico both is very close to the United States and has a lower credit rating than most industrial economies.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 976.

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    Date of creation: 2009
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    Handle: RePEc:fip:fedgif:976

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    Keywords: Dollar; American ; Foreign exchange rates;

    This paper has been announced in the following NEP Reports:

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    1. Jeffrey A. Frankel, 1985. "The Implications of Mean-Variance Optimization for Four Questions in International Macroeconomics," NBER Working Papers 1617, National Bureau of Economic Research, Inc.
    2. Engel, Charles & West, Kenneth D., 2006. "Taylor Rules and the Deutschmark: Dollar Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1175-1194, August.
    3. Nelson C. Mark, 2009. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1047-1070, 09.
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