Analyze the graphs below and answer the question that follows. Left, a bar graph titled Mexican Pesos per U S Dollar in 2008. The x-axis is labeled July, September, and November. The y-axis is labeled M X N 8 to M X N 14. July and September are over M X N 10. November is over M X N 12. Right, a bar graph titled British Pounds per U S Dollar in 2008. The x-axis is labeled July, September, and November. The y-axis is labeled 0.50 pounds to 0.70 pounds. July is near 0.50 pounds. September is 0.55 pounds. November is 0.65 pounds.

Data courtesy of RateX

The graphs above show the exchange rates between the US dollar and two other currencies in 2008. During the months shown, the number of Mexican pesos (MXN) in relation to one dollar rose from 10.2 to 13.1. The number of British pounds (£) in relation to one dollar also rose from .51 to .65.

Based on the graphs, did the value of the US dollar increase or decrease during these months?

The role of the exchange rate in financial crises has been well emphasised in the

literature.3 Past EM crises were typically preceded by large currency mismatches and

overvalued exchange rates, underlining the critical importance of the exchange rate

in the private sector’s decision to borrow in foreign currency. Another aspect of the

exchange rate regime is its interaction with financial development: while a flexible

exchange rate helps the development of hedging and local currency debt markets,

the degree of market development also influences the choice of exchange rate

flexibility.

Explanation: The Deputy Governors broadly agreed that increased exchange rate flexibility

can help to reduce currency mismatches, particularly the extent of foreign currency

borrowing. It was suggested that wrong incentives can be created by too stable an

exchange rate and, in some cases, by FX intervention. Claro and Soto in this volume

provide two main reasons for this observation: first, intervention to restrict

exchange rate flexibility can give a false sense of security for the private sector

regarding financial risks. Second, lower exchange rate volatility leads to higher

speculation about the future value of the currency, encouraging investors to exploit

the interest rate differential more aggressively (the so called “carry trade”). Both

factors create risks for the financial system.

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