History of Foreign Exchange

Gold Standard
The gold standard is a monetary system where the standard economic unit of account is based on the fixed weight of gold. A county under the gold standard would set a price for gold, say $100 an ounce and would buy and sell gold at that price. This effectively sets a value for the currency; according to the set example $1 would be worth 1/100th of an ounce of gold. Other precious metals could be used to set a monetary standard; silver standards were common in the 1800s. A combination of the gold and silver standard is known as bimetallism. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Each country used gold to back its currency. The gold standard lasted from 1876 to 1913. During most of the 1800s the United States was had a bimetallic system of money, however it was essentially on a gold standard as very little silver was traded. A true gold standard came to fruition in 1900 with the passage of the Gold Standard Act. The gold standard effectively came to an end in 1933 when President Franklin D. Roosevelt outlawed private gold ownership (except for the purposes of jewelry).

Bretton Woods Agreement

A landmark system for monetary and exchange rate management established in 1944 called The Bretton Woods Agreement was developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, from July 1 to July 22, 1944. Even as World War II raged on, 730 delegates from the 44 Allied nations attended the conference. Major outcomes of the Bretton Woods conference included the formation of the International Monetary Fund and the International Bank for Reconstruction and Development and, most importantly, the proposed introduction of an adjustable pegged foreign exchange rate system. Currencies were pegged to gold and the IMF was given the authority to intervene when an imbalance of payments arose.

One of the proposals of the Bretton Woods conference was that currencies should be convertible for trade and other current account transactions. This agreement lasted until 1971. During this period, governments would intervene to prevent exchange rates from moving more than 1 percent above or below their initially established levels.

Smithsonian Agreement
By 1971, the U.S. dollar appeared to be overvalued; the foreign demand for U.S. dollars was substantially less than the supply of dollars for sale (to be exchanged for other currencies). Representatives [a group of 10 countries (G10)] from the major nations met to discuss this dilemma. As a result of this conference, which led to the Smithsonian Agreement, the U.S. dollar was devalued relative to the other major currencies. The degree to which the dollar was devalued varied with each foreign currency. Not only was the dollars value reset, but exchange rates were also allowed to fluctuate by 2.25 percent in either direction from the newly set rates. This was the first step in letting market forces (supply and demand) determine the appropriate price of a currency. Although boundaries still existed for exchange rates, they were widened, allowing the currency values to move more freely toward their appropriate levels. However, the par value system began to lose its popularity in 1972-1975, and economic forces compelled several countries to switch.

Floating Exchange Rate System

Floating exchange rate system is a country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, floating exchange rates change freely and are determined by trading in the forex market. This is in contrast to a "fixed exchange rate" regime. As even after the Smithsonian Agreement, governments still had difficulty maintaining exchange rates within the stated boundaries, by March 1973, floating exchange rate system was introduced which is still being used.