Forex Walkthrough

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Level 2 Markets - History Of The Forex

We've learned a lot thus far and it's almost time to start trading, but given the global nature of the forex exchange market, it's important to first examine and learn some of the important historical events relating to currencies and currency exchange. In this section we'll take a look at the international monetary system and how it has evolved to its current state. Then we'll take a look at the major players that occupy the forex market - something that is important for all potential forex traders to understand.

The History of the Forex

Gold Standard System
The creation of the gold standard monetary system in 1875 is one of the most important events in the history of the forex market. Before the gold standard was created, countries would commonly use gold and silver as method of international payment. The main issue with using gold and silver for payment is that the value of these metals is greatly affected by global supply and demand. For example, the discovery of a new gold mine would drive gold prices down. (For background reading, see The Gold Standard Revisited.)

The basic idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency was backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had pegged an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first official means of currency exchange in history.

The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects, so they began printing more money to help pay for these projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the extra currency that the governments were printing off.

Although the gold standard would make a small comeback during the years between the wars, most countries had dropped it again by the onset of World War II. However, gold never stopped being the ultimate form of monetary value. (For more on this, read What Is Wrong With Gold? and Using Technical Analysis In The Gold Markets.)

Bretton Woods System
Before the end of World War II, the Allied nations felt the need to set up a monetary system in order to fill the void that was left when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies met in Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management.

To simplify, Bretton Woods led to the formation of the following:

  • A method of fixed exchange rates;
  • The U.S. dollar replacing the gold standard to become a primary reserve currency; and
  • The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).

The main feature of Bretton Woods was that the U.S. dollar replaced gold as the main standard of convertibility for the world's currencies. Furthermore, the U.S. dollar became the only currency in the world that would be backed by gold. (This turned out to be the primary reason why Bretton Woods eventually failed.)

Over the next 25 or so years, the system ran into a number of problems. By the early 1970s, U.S. gold reserves were so low that the U.S. Treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve.

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, essentially refusing to exchange U.S. dollars for gold. This event marked the end of Bretton Woods.

Even though Bretton Woods didn't last, it left an important legacy that still has a significant effect today. This legacy exists in the form of the three international agencies created in the 1940s: the International Monetary Fund, the International Bank for Reconstruction and Development (now part of the World Bank) and the General Agreement on Tariffs and Trade (GATT), which led to the World Trade Organization. (To learn more about Bretton Wood, read What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.)

History Of Exchange Rates
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