To get the whole picture of what the Foreign Exchange (FX, forex) market is and how it functions it’s worth reviewing some the most important historical events that have affected the currency markets in the past.
First, to understand how currency exchange rates came into being we need to go back to its roots in the gold standard.
The first shape of an exchange rate system was the gold standard which emerged in 18th century England.
What the gold standard means is that the government guarantees to exchange a certain amount of gold (usually 1 ounce) for a certain fixed amount of currency. Basically, that’s what is meant when we say the currency is backed by gold. Because in order for the government to be able to maintain the exchange rate of the currency to gold it must have large reserves of gold and it certainly can’t print as much money as it wants without control.
However, while this does create price stability sometimes more currency is needed, like during economic depressions and wars. And this proved to be the case in the past. Historically, during such times the gold standard was frequently abandoned and then returned when things got back to normal. Up until the end of the second World War, this is how things usually worked. This resulted in periods of hyperinflation, most famous of which was Germany in the 1920s.
Bretton Woods System
In 1944, at the end of WW2, the international world powers decided that they needed a new monetary standard and the Bretton Woods System was created. For this purpose, representatives from the Allied Forces and the Western world met in Bretton Woods, New Hampshire, USA.
They agreed to create a new monetary system, where the value of gold will be fixed only against the US Dollar at $35 per ounce, while the other currencies of the other participating nations will be only fixed against the value of the US dollar. From this event onwards, the US Dollar became and is still to this day the most dominant reserve currency in the world.
In addition to the foundation of the new monetary system, 3 international institutions were founded in Bretton Woods to watch and control global economic activity:
The International Monetary Fund (IMF)
the General Agreement on Tariffs and Trade (GATT)
The World Bank
End of the Bretton Woods System
However, even the US government couldn't maintain the fixed exchange rate of gold to the US Dollar and by 1971 didn’t have enough gold reserves to cover for the currency in circulation. Because of this, on 15 August 1971, then US President Richard Nixon had to abandon the gold currency. This practically made the US Dollar a fiat currency like the rest of the world currencies and marked the definite end of the Bretton Woods system and the gold standard.
Although the 3 international institutions formed in Bretton Woods are still functional today, the monetary concept of currencies being backed by gold is completely dead. Now, currencies are just paper with a value not backed by gold or any other physical asset, but only by the word of the government. That is to say, a currency has value simply because the government says so.
This is probably also the reason why the whole speculation and online forex trading grown last years that much (of course, together with technology / computer innovations). Today's market moves, volatility and fluctuating prices create unique opportunities for forex traders.
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