Exchange Rate Policy

The exchange rate — the price of one currency in terms of another — is a critical macroeconomic variable that affects trade, inflation, investment, and living standards. Governments and central banks must decide how to manage their exchange rate, choosing from a spectrum of regimes ranging from freely floating to rigidly fixed. The UK's experience, including the traumatic exit from the European Exchange Rate Mechanism (ERM) in 1992, provides essential case study material for A-Level Economics.

Key Definition: The exchange rate is the price of one currency expressed in terms of another currency. For example, £1 = $1.27 means one pound sterling can be exchanged for 1.27 US dollars.

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Exchange Rate Regimes

1. Freely Floating Exchange Rate

Under a floating exchange rate system, the value of the currency is determined entirely by market forces of demand and supply in the foreign exchange (forex) market. The central bank does not intervene to influence the exchange rate.

Demand for sterling arises from:

• Foreign buyers purchasing UK exports (they need pounds to pay UK firms).
• Foreign investors buying UK assets (shares, bonds, property).
• Speculators expecting sterling to appreciate.
• Foreign tourists visiting the UK.

Supply of sterling arises from:

• UK buyers purchasing imports (they sell pounds to buy foreign currency).
• UK investors buying foreign assets.
• Speculators expecting sterling to depreciate.
• UK tourists travelling abroad.

Advantages of floating rates:

Advantage	Explanation
Automatic adjustment	If the UK runs a current account deficit, demand for sterling falls, the pound depreciates, making exports cheaper and imports dearer — helping to correct the deficit
Monetary policy independence	The central bank is free to set interest rates for domestic objectives (inflation targeting) rather than defending a fixed exchange rate
No need for foreign currency reserves	The government does not need to hold large reserves of foreign currencies for intervention
Absorbs external shocks	The exchange rate can adjust to cushion the economy from external shocks (e.g., oil price changes, foreign recessions)

Disadvantages of floating rates:

Disadvantage	Explanation
Volatility and uncertainty	Exchange rate fluctuations create uncertainty for businesses engaged in international trade and investment, increasing hedging costs
Speculative capital flows	Short-term capital movements driven by speculation can cause exchange rate overshooting, departing from fundamental values
Imported inflation	A depreciation increases the price of imports, potentially fuelling cost-push inflation
No automatic discipline	A floating rate does not impose discipline on domestic fiscal or monetary policy

The UK has operated a floating exchange rate since September 1992 (following ERM exit).

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2. Fixed Exchange Rate

Under a fixed (or pegged) exchange rate system, the government or central bank commits to maintaining the exchange rate at a specific value (or within a narrow band) against another currency or basket of currencies.

How the rate is maintained:

• If the pound is above the fixed rate (currency is too strong), the central bank sells pounds and buys foreign currency, increasing supply of sterling and pushing the rate down.
• If the pound is below the fixed rate (currency is too weak), the central bank buys pounds using its foreign currency reserves, increasing demand for sterling and pushing the rate up.
• Interest rates may also be adjusted to defend the peg — higher rates attract foreign capital, supporting the exchange rate.

Advantages:

Advantage	Explanation
Certainty for trade and investment	Businesses can plan without worrying about exchange rate fluctuations
Discipline on domestic policy	The government must maintain low inflation and sound finances to sustain the peg
Reduces speculation	A credible fixed rate eliminates the profit opportunity from currency speculation

Disadvantages:

Disadvantage	Explanation
Loss of monetary policy independence	Interest rates must be set to defend the exchange rate, not to manage domestic inflation or growth
Requires large foreign currency reserves	Defending the peg against market pressure can be very expensive
Risk of speculative attack	If markets believe the peg is unsustainable, they will sell the currency aggressively, potentially forcing a disorderly devaluation
May be set at the wrong level	If the fixed rate does not reflect economic fundamentals, it can make exports uncompetitive (rate too high) or fuel inflation (rate too low)

Exam Tip: The key trade-off with a fixed exchange rate is the loss of monetary policy independence. Under a fixed rate, the central bank cannot use interest rates to target domestic inflation — it must use them to defend the exchange rate. This is a fundamental constraint.

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3. Managed Float

A managed float (also called a "dirty float") is an intermediate regime. The exchange rate is primarily determined by market forces, but the central bank intervenes occasionally to smooth excessive volatility or prevent the rate from moving to a level deemed harmful to the economy.

Most countries in practice operate some form of managed float. Even under the UK's officially floating regime, the Bank of England retains the option to intervene if necessary, though it has rarely done so since 1992.

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The ERM Crisis: Black Wednesday (16 September 1992)

The UK's experience in the ERM is one of the most important exchange rate policy case studies in economic history.

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