The foreign exchange market has gone through several major transitions over the years, moving through prolonged periods of fixed and floating exchange rate systems
Most forex traders these days are very familiar with the currently popular system of floating exchange rates.
Nevertheless, exchange rates among the major currencies were fixed or pegged for many years and were even tied to the price of valuable commodities like gold.
The Bretton Woods Accord Fixed Exchange Rates
The Bretton Woods Accord was signed in 1945 in the aftermath of World War II and fixed currency exchange rates for many years relative to each other and to the value of the U.S. Dollar, which in turn had its price fixed relative to the price of gold.
Overall, this system led to a “golden era” time of economic stability and growth for the major developed countries during which the exchange rates among their currencies generally did not fluctuate very much.
Currencies also generally kept their value over time, although devaluations were permitted in times of economic hardship.
Nevertheless, speculative pressures built up and started hoarding gold, so in 1971, U.S. President Richard Nixon acted to suspend the convertibility of the U.S. Dollar into gold.
This unilateral move effectively took the Dollar off of the Gold Standard and eventually led to the downfall of the Bretton Woods system of fixed exchange rates. The final nail in the system’s coffin was the abandonment of capital controls by the United States in 1974.
Bretton Woods was subsequently replaced with a system of floating exchange rates that prevails to the modern era for the currencies of most developed countries, and the period since 1980 is sometimes known as the Washington Consensus.
Modern Exchange Rate Regimes
Currently, most governments use one of three different exchange rate systems:
- Managed Floating Exchange Rate – This is the system that most developed nations use. In this system, the currency is allowed to float against all other currencies thereby letting market forces determine the value of the currency. The central bank may however step in to intervene in the currency markets or with interest rate changes to prevent extreme or unwanted movements.
- Pegged Exchange Rate – This system involves a country fixing their exchange rate to another currency, usually that of a major trading partner. For example, the Chinese Yuan is currently pegged to the U.S. Dollar, so when the Dollar moves, the Yuan will move along with it. This allows the currency more stability than a free floating exchange rate, and in the case of China, it allows the central bank to keep its currency at an artificially low value.
- Dollarization – Often used by developing countries, this system means a country uses a foreign currency like the U.S. Dollar instead of issuing its own currency. While this system provides currency stability, it impedes the country from developing its own monetary policy.
The Dollar’s Value is Now Tied Solely to Its Issuer’s Credit
Originally, the Dollar was allowed to float in the early 1970’s as a temporary measure to curb currency speculation. Nevertheless, the Dollar’s separation from the stability of the gold standard led to even more widespread speculation in the currency markets that continues to the present day.
Before 1971, the Dollar had been a representative or commodity currency, backed by the value of gold. After 1971, the Dollar became a “fiat” currency or a paper currency that has only been given value by a government decree or fiat.
Fiat money has no intrinsic value other than the creditworthiness of the issuer and is only a promise by the issuer to pay back debts.
As a result, the value of the Dollar fluctuates considerably as the fortunes of the United States change in the perceptions of the forex market.