The concept of foreign exchange or forex in the context of world economy has evolved over a long period of time, let us read about the history of forex and the major events that reformed the world of forex to create and maintain complete awareness about forex history.
The Barter System
In ancient times, trade was based on the barter system at the community level and there was no need for a currency. Under this system, the value of goods was expressed in terms of other goods and these values were measured in different and the exchange was generally unilateral though it was multilateral at times. But since this system had some limitations, various alternatives were developed.
Before we read about these alternatives, let us read about limitations of the barter system.
1. In a barter economy, it is difficult to measure the value of all goods.
2. A barter transaction cannot occur if an individual wants to buy a specific amount of goods belonging to another individual. Since some products cannot be divided due to their intrinsic characteristics, the barter system failed to live up to expectations of the market and its constituents.
3. Some barter economies relied on non-durable and perishable goods that pose a difficulty in storing wealth over a period of time.
The Gold Standard System
Due to limitations of the barter system, a hunt for efficient alternative soon found its answer in gold, the yellow metal. The reasons why the metal became a success was because it was difficult to find new sources of gold, it could not be manufactured or printed, and it was not easily mined and since it was the most ductile and malleable of all metals, gold became the world's preferred choice for exchange. However, the fact that gold is not easy to transport due to its weight, world governments started printing bills or notes.
Bills and Notes
Though bills and notes weigh lighter than their previous counterparts, but governments made a mockery of them by printing more money to pay themselves and others rendering this form of currency worthless. This in turn led to dependence on hard currency (paper currency), backed by gold, which is considered as a trusted source of a stable country since no one is interested in buying or selling a currency that is continually devaluing.
Hard or paper currency backed by gold has many advantages for an economy. Since almost every nation had gold and most individuals were familiar with it, this form of currency offered a common measure of value. Moreover, this currency form helped in stabilizing economies since it kept the money supply based on the gold standard limited. In addition to that, this form of currency inhibits the amount of currency that can be printed by tying the amount of currency to the quantity of gold that an economy possesses.
Collapse of the Gold Standard
Since an economy runs the risk of losing more and more gold if it fails to stay competitive, the gold standard soon lost its sheen. The fact that a world economy would have to contract the supply of money with less gold in stock (less money in circulation lowers income, output, and employment and more of money leads to increased employment, income, and output), there were few takers for this standard. Countries started to increase the money supply during this time for stimulating their economies by abandoning the gold standard in the throes of the Great Depression.
Bretton Woods and Adjustable-Peg System
Leaders of the allied nations had a meeting at Bretton Woods, New Hampshire in 1944, to establish a better system of fixed exchange rates. The United States dollar (USD) was fixed at $35 per ounce of gold and other world currencies were expressed in terms of dollars and the official fixed rate of exchange was termed as the par value of currency or par exchange rate.
The new system, however, provided for an adjustable peg to avoid making deleterious macroeconomic adjustments to maintain the exchange rate and facilitated the exchange rate to be altered under specific circumstances. Thus, the Bretton Woods system was also known as the adjustable-peg system and the International Monetary Fund (IMF) was created to bring this new system in effect.
Under this new system, each country was expected to value its currency in terms of USD or gold that fixed the exchange rate among all currencies. Every country had to maintain an account at the International Monetary Fund and this account was proportional to its volume of trade, national income, and population.
The Bretton Woods system began to weaken in the 1960s when foreigners started accumulating large amounts of USD from post World War II aid and export sales in the United States and the market was full of doubts whether the United States had enough gold to redeem all the dollars. The US decided to abandon this system with reserves of gold falling steadily. U.S. President Richard Nixon in 1971 made an announcement that the USD would no longer be convertible into gold and the exchange rate was allowed to float. Since the US played an important role in sustaining the Bretton Woods system, the system came to an end with its absence. The development also prompted the arrival of a system of managed floating exchange rates in 1973 that exist even today.
Managed Floating Exchange Rate
This exchange rate mostly floats but can be changed sometimes by nations and the changes are generally effected by their central banks by making a direct intervention in the foreign exchange market by buying or selling the currency that the nation wants to influence to have an effect on demand and supply. This system allowed nations of the world to manage their own economies through monetary policy and expand the money supply to stimulate the economy, or contracting it to rein in inflation.
In the year 1973, the Jamaican exchange system was introduced with the attendance of 20 major economically developed countries of non-Communist alliance. The exchange system was followed by the introduction of the foreign exchange market or forex market on 8th of January, 1976 and free floating exchange rate became the only method of currency exchange from this period of time.
The forex market has now became a worldwide decentralized over-the-counter financial market for currency trading with worldwide financial centers acting as trading anchors between a wide range of different types of buyers and sellers around the clock. This form of trading has become popular with profit-oriented investors due to its huge trading volume, liquidity, geographical dispersion, its continuous operation, and low margins of relative profit compared with other markets of fixed income. The average daily turnover in global foreign exchange markets estimated at $3.98 trillion as of April 2010 (according to the Bank for International Settlements) that reflects a growth of approximately 20 percent over the $3.21 trillion daily volume as of April 2007 is a huge testament to the evolution of forex today.