Exchange rate policy

The exchange rate of an economy affects aggregate demand through its effect on export and import
prices, and policy makers may exploit this connection.
Deliberately altering exchange rates to influence the macro-economic environment may be regarded
as a type of monetary policy. Changes in exchanges rates initially work there way into an economy
via their effect on prices.
For example, if 1 exchanges for $1.50 on the foreign exchange market, a UK product selling for 10
in the UK will sell for $15 in New York. If the exchange rate now appreciates, so that 1 buys $1.60,
the UK product in New York will now sell for $16. Assuming that demand in New York is price
inelastic, this is good news for UK exporters because revenue in USDs will rise. However, if demand
is elastic in New York, the effect of the appreciation of the Pound would be damaging to UK
exporters.
If the UK also imports goods from the USA, the rise in the exchange rate would mean that a $10 US
product is now cheaper in London, falling from 6.67p to 6.25p. Importers do relatively well from
the appreciation of the pound, in that the cost of imported raw materials or finished goods falls.
Therefore, whenever the exchange rate changes there will be a double effect, on both import and
export prices. Changes in import and export prices will lead to changes in import and export
volumes, causing changes in import spending and export revenue.
Exchange rates can be manipulated so that they deviate from their natural equilibrium rate. To
stimulate exports, rates would be held down, and to reduce inflationary pressure rates would be
kept up. While the Bank of England does not specifically target the exchange rate, the Monetary
Policy Committee (MPC) will take exchange rates into account. Clearly, the MPC would prefer a
relatively high rate, as this reduces the price of imports and works against inflationary pressure.
However, the MPC must keep an eye on export competitiveness, and, if rates rise excessively, UK
exports will become uncompetitive.
How exchange rates are manipulated:
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. Rates can also be manipulated through interest rates, which affect the demand and supply
of Sterling via their effect on inflows of hot money. Altering exchange rates is commonly regarded as
a type of monetary policy.
Effects of a reduction in the exchange rate:
Assuming the economy has an output gap, a reduction in the exchange rate will reduce export
prices, and, assuming demand is elastic, export revenue will increase.

A fall in the exchange rate will also raise import prices, and assuming elasticity of demand, import
spending will fall. The combined effect is an increase in AD and an improvement in the UK balance of
payments.
Cost push inflation:
A fall in the exchange rate is inflationary for a second reason - the cost of imported raw materials
adds to production costs and creates cost-push inflation.

http://www.economicsonline.co.uk/Managing_the_economy/Exchange_rate_policy.html