Final answer:
Investors are likely to invest in Mexico where the interest rate is higher, leading to a potential appreciation of the Mexican peso. This occurs as demand for the higher-yielding currency increases, and monetary policy can further impact these exchange rates.
Step-by-step explanation:
When looking at differences in rates of return across countries, investors are motivated to earn the highest return possible on their investments. If investors can earn ten percent interest in an account in Mexico but just three percent in the US, they will be inclined to invest their funds in Mexico where the rate of return is higher. This inflow of funds into Mexico would lead to a shift in demand and supply for the Mexican currency, potentially causing it to appreciate. Conversely, the U.S. dollar might depreciate because there would be less demand for it in the foreign exchange market as investors seek higher yields elsewhere.
Changes in interest rates can impact currency exchange rates as investors buy interest-bearing assets in countries with higher returns. A rise in U.S. interest rates compared with Mexico, for instance, increases demand for U.S. dollars and can make the dollar appreciate. In the scenario, with higher rates in Mexico, we would expect the reverse as investors chase the higher returns offered by Mexican accounts, which can lead to an appreciation of the Mexican peso. Monetary policy decisions by a nation's central bank can thus influence interest rates and, consequently, exchange rates and currency strength.