The exchange rate works effectively through the interest rate policy because if the interest rates are raised to attractive for the foreign investors levels, there will be an inflow of money from abroad. This inflow of money will increase the demand for domestic money increasing the exchange rate.

In the UK the demand for money increased and with the increase in the money supply resulted to a deep financial deregulation of the financial markets (Big Bang). This increased competition between the financial institutions, which took more risks and increased lending. This action increased the demand for money, because of the easier access to credit, resulting to a spectacular boom in consumption and a fast GDP growth rate.

Under this system the EU member countries try to maintain considerable stability between their currencies. Although the exchange rates were not fixed most countries tried to maintain their currencies within 2.25% of an agreed value against each other member's currency. UK joined the ERM later than the other countries and was allowed to fluctuate by as much as 6%. This extra freedom was the result of the fact that the country had relatively high inflation before 1990 so the sterling was not very stable in relation to the other currencies. With high inflation sterling had a high value and it would be difficult to maintain this value if interest rates were dropped.

Although the ERM was a successful instrument of monetary policy it caused many problems to the British economy. There was severe depression and a collapse of the house prices, which undermined the private sector wealth. Moreover unemployment increased to 3 millions and public borrowing was too high. At the end of 1991 the German interest rates were increased which forced the UK to tighten monetary policy, in order to keep interest rates high to reduce inflation and to protect its exchange rate. On the 20th of September on Black Wednesday, the pressure of the pound drove the Bank of England to increase interest rates from 10 to 15%.

The hoped-for "soft handling" of the UK economy materialised in 1996, when GDP increased further, unemployment continued to decline, and inflation fluctuated between 2.8% and 3.3%. From January to the end of September sterling strengthened gradually from 83.4 to 86.1 according to the Bank's exchange rate index and finished the year at 96.1, an appreciation of 11.6%.

Afterwards the interest rates were raised to anticipate inflation and excess demand so credibility was managed and provided some freedom to the exchange rate and interest rate policies. High interest rates and relatively high exchange rates drove the economy into recession.

The next step for the UK monetary policy was to maintain a fixed level of exchange rate, by entering the Exchange Rate Mechanism (ERM) in 1990. . This entry was seen as the key form of targeting the exchange rate and tended to be associated wi

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