Monetary policy and exchange rates are closely related; exchange rates can affect both inflation and employment, which are two of the main targets of monetary policy. The decision to fix exchange rates, attempt to manage them, or leave them to float freely, is itself part of monetary policy. In principle, monetary policy is any decision that affects the availability and cost of money, both as cash and credit. It is the counterpart to fiscal policy, which involves public spending and taxation. The various elements of monetary policy and exchange rates have a symbiotic relationship, meaning each can affect the other or others.
Exchange rates can have a key effect on inflation. A low exchange rate means that imported goods become more expensive in the domestic currency. Depending on how much of a country's goods are imported rather than domestically produced, this can significantly increase inflationary pressures. This is more likely to have an effect in countries that lack natural resources and domestic production capacity, meaning consumers can't simply switch to a cheaper domestic supplier.
Monetary policy and exchange rates are also connected in terms of employment. The same low exchange rate will make domestically produced goods cheaper to foreign buyers, which will in turn help domestic businesses receive more orders and need to take on staff. This is a good example of the difficulty of balancing different measures in monetary policy: the same low exchange rate has led to high employment, which is generally a positive, but high inflation, which is generally a negative.
There are widely varying levels of attempted control in monetary policy and exchange rates are no different. Some countries try to completely fix exchange rates, for example by placing legal restrictions on imports and exports and the movement of currency. Some countries let exchange rates float without any controls at all. Most lie somewhere in between, for example by having a policy of buying and selling currency to manipulate rates only in the event of rates reaching extreme levels.
Some other aspects of monetary policy can indirectly affect exchange rates. For example, if a country sets high bank base rates, commercial banks will be more likely to offer higher rates to savers, while businesses will need to offer higher rates to investors in corporate bonds. These high rates may attract investors from other countries, who will therefore need to exchange their own currency for that of the country they are investing in. This will increase demand for the currency, which will usually lead to a higher exchange rate.
