Foreign Exchange Markets

Foreign Exchange Markets

In The Beginning

Foreign exchange dealing may be traced back to the early stages of history, possibly beginning with the introduction of coinage by the ancient Egyptians, and the use of paper notes by the Babylonians. Certainly by biblical times, the Middle East saw a rudimentary international monetary system when the Roman gold coin aureus gained worldwide acceptance followed by the silver denarius, both a common stock among money changers of the period.

(History of Currency 2007).

As the Middle Ages approached, international banking had become the way of foreign exchange. The use of bills where used as payment for merchant prices. By 1816 the gold standard was a fixed commodity (History of Currency 2007); The gold standard was taken up by trading countries: “When countries agree to buy or sell gold for an established number of currency units” (Rue 2004 pg 147). The countries that participated had decided on a fixed physical weight of gold, which the currency would circulation. This would make the currency directly redeemable with the valuable metal. Towards the end of 1879, the U.S. dollar transferred to the use of the gold standard that became the standard-bearer, which replaced the British pound when Britain and other European countries as World War I came about in 1914. Things worsened as the international depression had taken the dollar off the gold standard by 1933; This was known as the collapse in international trade as World War II approached. World War II destroyed Great Britain’s economy and the United States practically untouched. This made it the logical choice for becoming the reserved currency to the international financial markets.

45 countries were present at the United States request in 1945 to plan a new international financial solution. The plan was the Bretton Woods System, which was “A New Hampshire town where treasury and central bank representatives met near the end of World War II; they established the MF, the World Bank, and the gold exchange standard”. (Rue 2004 pg 148) The system was designed to avoid a repeat of the 1930’s global depression. The United States dollar was now the new global reserve currency that is value fixed into gold.

Among the key features of the new framework were:

1. Fixed but adjustable exchange rate

2. The International Monetary Fund

3. The World Bank

(History of Currency 2007)

At the core of Bretton woods' problems were deteriorating confidence in the dollars' ability to maintain full convertibility and the unwillingness of surplus countries to revalue for its adverse impact in external trade. Despite a last-ditch effort by the Group of Ten finance ministers through the Smithsonian Agreement in December 1971, the international financial system from 1973 onwards saw market-driven floating exchange rates taking hold. Several times efforts for Reestablishing controlled systems were undertaken with varying levels of success. The most well known of these was Europe's Exchange Rate Mechanism of the 1990s which eventually led to the European Monetary Union. (History of Currency 2007)

Gold standard is when countries buy or sell gold equaling a number of currency units. There are negative aspects of the gold standard act such as it was difficult to operate and the government can’t control amount of money supply. But there is a positive, money would have standard value and congress would not be able to spend more than they have meaning that you can’t make money when you don’t have gold to back it up.

Under another system, the gold standard, U.S. households and businesses could exchange their dollars for gold. This practice was abandoned in 1933 during the Great Depression to allow freer expansion of money supply. However, foreign governments were still able to exchange their dollars for gold until 1971, when the United States terminated the gold-exchange standard entirely.

(Federal Reserve Bank)

Functions of