In the past, the value of goods and services were expressed in terms of other goods. This exchange system was called the barter system. The first coins to be used as a medium of exchange were made from gold and silver. Later on, during the Middle Ages, people began to use paper money to exchange value as an I.O.U. However, the foreign exchange industry itself is the newest of the financial markets.
During the last century, the foreign exchange market has undergone some dramatic transformations.
Prior to WWI, central banks supported their currencies through convertibility to gold. Paper
money could be converted into gold on request to the bank. Since it was not likely that
all holders of paper money would request gold at the same time, banks only needed to
keep a determined amount of gold on hand in order to handle normal exchange requests
(gold reserves). And so, the amount of money outstanding was increased relative to the
amount of actual gold the bank has on hand. As a result, during times of crisis, when the
confidence of the financial system was low, Banks experienced a “run on the bank.” This
was when a large amount of currency holders requested conversion into gold at the same time, especially if it was more gold than the bank had on hand.
In 1944, foreign exchange controls were introduced in a bid to control the forces of supply and demand, with the intention of structuring the world economic system in a way that would stabilize the volatile foreign exchange markets. And so in July 1944, towards the end of WWII, the Allied countries (U.S., Great Britain, and France) met at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire and
established the postwar foreign exchange system.
The Bretton Woods conference determined a system for pegging currencies and created the International Monetary Fund. The Accord fixed the US Dollar at $35 per ounce of gold and fixed other currencies to the dollar.
During the 1960s, the volatility between different country economies became more
extreme, making it difficult for some to maintain the pegging system.
The Bretton Woods control system collapsed in 1971, when President Nixon suspended
the gold convertibility standard. The dollar had lost its attraction as the sole international currency due to the impact of growing trade deficits and government budget deficits.
During the 70’s, the European community tried to move away from their dependency on
the dollar. The European Joint Float was established by West Germany, France, Italy, the
Netherlands, Belgium and Luxemburg and in 1979, the free-floating system was officially
The Birth of the Euro
The quest continued in Europe for currency stability with the 1992 signing of The Maastricht
treaty. This was to not only fix exchange rates but also actually replace many of them with
the Euro in 2002.
Floating Exchanges Systems
Under a floating exchange system, currencies are not valued in terms of gold – they are
valued in terms of other currencies.
In the early 20th century, two world wars brought about social upheavals, rapid inflation,
and the destruction of the setting which made the gold standard operable. Between
the wars, many countries elected to temporarily abandon the gold standard and opt for
floating exchange systems until their economies returned to the point at which if a currency
drifted too far outside its band and could not be contained by central bank intervention,
the country was allowed to adjust its peg by setting a new exchange rate. With the
instability brought about by the Vietnam War, central banks finally began to convert their
dollars to gold.
To halt the loss of gold, in 1971 Nixon “closed the gold window” by
refusing to provide gold to foreign dollar holders. In 1974 the Bretton Woods System
of adjustable pegs was officially abandoned, and the subsequent Jamaica Agreement
basically allowed the presence of any exchange system a country chose to use.