Europe - The euro
Theory 2 - The ERM? - erm, what was it?
The Exchange Rate Mechanism (ERM) was a part of the European Monetary System (EMS). All the members of the ERM fixed the values of their currencies together, and then allowed the exchange rate to fluctuate a small amount either side of this fixed value. For most countries the rate fluctuated 2ΒΌ% either side of the fixed value, but when the UK joined, sterling was allowed to fluctuate by 6% either side.
If the currency got close to its limit, then the country would have to intervene to ensure it didn't go through the limit. In the short-run, this may have required the government to buy or sell from their foreign exchange reserves as relevant, but in the longer-term they would probably need to alter the level of interest rates.
Let's look at an example. In the diagram below, the UK's fixed rate is DM2.95 (as it was when we were members). The exchange rate can fluctuate up to 6% either side of this.
A lack of demand for sterling has shifted the demand curve to the left, so that the exchange rate is dangerously close to the lower limit. There is every likelihood that if the government do nothing, demand will fall further, so they have to act. In the short-term, they decide to sell other currencies from their reserves and buy sterling. This creates a bit more demand for sterling and stops it falling. It may even shift the demand curve to the right and push it up a bit. However, they need to do more as the markets are still lacking in confidence in sterling. They therefore decide to increase interest rates. This will attract flows of investment ('hot money') into the UK. This raises the demand for sterling and pushes the demand curve to D2. Crisis is averted (for the moment?).
The effect of the ERM was to reduce inflation in other countries to the level of the lowest inflation country. To see why this happened, let's say that the UK has much higher inflation than Germany. This is what is likely to happen:
Higher inflation in UK 
exchange rate depreciates against the Deutschmark exchange rate is pushed towards lower ERM limit government raises interest rates to protect exchange rate higher interest rates reduce the level of aggregate demand lower aggregate demand lowers demand-pull inflation until closer to that of Germany.
So higher inflation automatically led to interest rates changing to help get rid of the inflation, through exchange rate changes.
