EFFECTS OF U.S. INTEREST RATES ON THE REAL EXCHANGE RATE IN MEXICO

Abstract

Using monthly data to bond and equity markets in Mexico from U.S. investors, we search for responses in the vector autoregressions (VARs) - on the real exchange rate and reserves in Mexico - to shocks in U.S. interest rates and to the Mexican M2/Reserves ratio over the years 1988-2001. The ratio M2/Reserves measures the degree of financial vulnerability and brings this literature closer to theoretical constructions. Shocks to U.S. interest rates explain not more than 7.4% of the variance of international reserves and only 5.5% of real exchange rate changes under conventional specifications. Blending M2/Reserves with real exchange rates at the end of the VAR, external shocks explain 12.5% of the variance of real exchange rate one year after the shock and 12.8% of the variance of M2/Reserves. Typically, the responses in Mexico of U.S. interest rate shocks are as expected: higher shocks to U.S. interest rates move Mexican M2/Reserves up, depreciating the real exchange rate in Mexico.