The Puzzling Peso

47 Pages Posted: 26 Sep 2009

See all articles by Carlos Oscar Arteta

Carlos Oscar Arteta

Board of Governors of the Federal Reserve - Division of International Finance (IFDP)

Steven B. Kamin

Board of Governors of the Federal Reserve System

Justin Vitanza

Board of Governors of the Federal Reserve System

Date Written: September 11, 2009

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.

Keywords: Mexico, peso, dollar, exchange rates, interest rate differentials, inflation, output gap, output growth differentials

JEL Classification: F30, F31

Suggested Citation

Arteta, Carlos Oscar and Kamin, Steven B. and Vitanza, Justin, The Puzzling Peso (September 11, 2009). FRB International Finance Discussion Paper No. 976. Available at SSRN: https://ssrn.com/abstract=1478574 or http://dx.doi.org/10.2139/ssrn.1478574

Carlos Oscar Arteta (Contact Author)

Board of Governors of the Federal Reserve - Division of International Finance (IFDP) ( email )

20th St. and Constitution Ave.
Mail Stop 24
Washington, DC 20551
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202-452-2762 (Phone)
202-736-5638 (Fax)

HOME PAGE: http://www.federalreserve.gov/research/staff/artetacarloso.htm

Steven B. Kamin

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-3339 (Phone)
202-736-5638 (Fax)

Justin Vitanza

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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