The exchange rate of an economy affects aggregate demand through its effect on exports and imports, and policy makers can exploit this connection.
Exchange rates can be manipulated so that they deviate from their natural rate. Many economists regard exchange rate manipulation as a type of monetary policy.
Rates need to be held down to stimulate exports, and pushed up to reduce inflationary pressure. While the Bank of England does not specifically target the exchange rate, the MPC will consider exchange rates. Clearly, during times of inflationary pressure the MPC would prefer a relatively high rate as this reduces the price of imports and works to dampen inflationary pressure. However, the MPC must keep an eye on export competitiveness, and if rates move too high UK exports will become uncompetitive.
Exchange rates can be manipulated by buying or selling currencies on the foreign exchange market. To raise the value of the pound the Bank of England buys pounds, and to lower the value, it sells pounds. The Bank of England can influence exchange rates through its Exchange Equalisation Account (EEA). This account, which holds the UK's gold and foreign currency reserves, and its holdings of IMF Special Drawing Rights (SDRs), was specifically established in 1932 to stabilise the value of the pound, though its role is now much wider.
Rates can also be manipulated through interest rates, which affect the demand and supply of Sterling via their effect on inflows of hot money.
Some currencies are subject to exchange controls by the relevant national central bank. This means that the central bank will only allow buying and selling through their own system, rather than be subject to the level of fluctuation associated with fully floating rates. Although most countries abandoned exchange controls many years ago, some, like China and Cuba still practice exchange rate control, though controls in China were relaxed in 2006.
See: article in China Daily
Assuming the economy has an output gap, a reduction in Sterling will reduce export prices, and, assuming demand is elastic, raise export revenue.
It will also raise import prices, and assuming elasticity of demand is greater than one, reduce import spending. The combined effect is an increase in AD and an improvement in the UK balance of payments.
The main advantage of manipulating exchange rates is that, because a large share of UK output is traded internationally, changes in exchange rates will have a powerful effect on aggregate demand.
For example, lowering exchange rates (called devaluation) can:
Raise aggregate demand
Increase national output (GDP)
Alternatively raising exchange rates (revaluation) can:
Help reduce excessive aggregate demand
Keep inflation down
Though the export sector may suffer and jobs can be lost
On balance, UK policy makers in recent years have preferred to allow the financial markets to determine exchange rates, rather than manipulate them for policy objectives. The last time exchange rates were directly targeted was between 1985 and 1990, when the UK shadowed movements in the Deutschmark, and then, from 1990 to 1992, became a member of the exchange rate fixing Exchange Rate Mechanism (ERM). However, in the eurozone-17, there is a much greater emphasis on keeping the exchange rate stable, as this is a central pillar of euro-area policy.