In this section we link together changes in macroeconomic conditions and the impact on exchange rates. Assume domestic economic growth increases relative to foreign growth rates. Increase purchases of imported goods and the supply of dollars to foreign exchange markets. A rise in the domestic inflation rate. As the prices of domestically produced goods rise, consumers may substitute in favor of imports that are now relatively cheaper.
Foreign consumers substitute away from exports that are increasing in price.
The Fed reacts to higher domestic inflation by raising interest rates. Net inflow of money into the economy through the capital account and increase demand for dollars. The statistics confirm Mexico's situation.