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.