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History of Foreign Exchange
In this part we shall have a look at the evolution of money and the various exchange rate systems prevailing till the middle of the 20th century. The exchange of goods and services has been prevalent since thousands of years and a system of barter developed over the years as man looked for ways to fulfill his needs for different commodities and services. The initial exchange was limited to items of food and gradually as man explored, invented and traveled to distant land it became necessary to have a medium of exchange. This necessity led to the evolution of money.
The Evolution of money
Primitive societies used various commodities as a medium of exchange. These ranged from grain, shells, tobacco, rice, salt, ivory to cattle, sheep, skins and slaves. These were the commodities, which were in greater demand and were thus easy to exchange. However, while a farmer could easily meet his requirements for various goods by offering his wheat, a person having cattle would find it difficult to exchange it for salt. He would either have to take a very large quantity or take some other easily traded commodity. Thus the marketability of a commodity determined its acceptance and use as a means of exchange. Marketability of a commodity was determined by the familiarity with the commodity and its quality, divisibility, uniformity and ease of transportation and storage.
Over time, with the introduction of metals and coins, another important quality of the commodity emerged. It became a medium of exchange, having a value much greater than its intrinsic value. It was no longer used for consumption, but for acquiring other commodities for consumption. This was the evolution of ‘money’.
The use of coins facilitated exchange as it was easy to determine the value of a unit, was easily divisible and acceptable to all. Two metals, gold and silver were favoured for minting of coins because of their intrinsic value. There however still remained the inconvenience of carrying a large amount of coins or bullion and it was not easy to transfer or transport large amounts.
It was in the 17th century that the practice of depositing coins and bullion with goldsmiths, moneychangers, mint masters etc started. These persons enjoyed the trust of the people and were entrusted with the job of safe keeping of surplus money. The next step was the transfer of value by assignment rather than by physical delivery. Goldsmiths in England were among the first to start the system of money by book entry.
This was a major development and ultimately led to the spread of banking services. People were confident that they would receive a certain value, on demand, against the bank note they possessed.
The history of foreign exchange can be traced back to the time moneychangers in the middle east would exchange coins from all over the world. Foreign exchange dealings with gold as the standard of value started around 1880 after more than a hundred years of bimetallism where both gold and silver were commonly used as a measure of value.
The Gold Standard
Under the gold standard, the exchange rate of two currencies was based on the intrinsic value of gold in the unit of each currency. This also came to be known as the mint parity theory of exchange rates.
Under the gold standard exchange rates could only fluctuate within a narrow band known as the upper and lower gold points. A country, which had a balance of payments deficit had to part with some of its gold and transfer it to the other country. The transfer of gold would reduce the volume of money in the deficit country and lead to deflation while the inflow of gold in the surplus country would have an inflationary impact on that economy. The country which was in deficit would then be able to export more and restrict its imports as a result of the fall in domestic prices and reduce its BOP deficits. A lowering of the discount rates in a country with a surplus and a hike in discount rates in the deficit country also aided in reducing the imbalance in the BOP.
The main types of gold standard were:
The gold specie standard. § The Gold Bullion standard. § The Gold Exchange standard.
The Gold Specie Standard – 1880-1914
Under the gold specie standard, gold was recognized as a means of settling domestic as well as international payments. There were no restrictions on the use of gold and it could be melted down or be sent to a mint for conversion to coins. Import and export of gold was freely allowed and Central Banks guaranteed the issue or purchase of gold at a fixed price, on demand. The price of gold varied according to the supply of the metal in the market and the value of gold coins was based on their intrinsic value.
The Gold Bullion Standard 1922-1936
The gold bullion standard started after the first world war, as increased expenditures to fund the war effort exposed the weaknesses of the gold standard. It was decided at an international conference in Brussels in 1922 to reintroduce the gold standard but in a modified form. Under the gold bullion standard, paper money was the main form of exchange. It could however be exchanged for gold at any time. As it was unlikely that there would be a great demand for converting currency notes to gold at any given time, the banks could issue currency notes in excess of the value of gold they were holding. The gold bullion standard too could not last long as many major currencies were highly over or under valued leading to a distortion in balance of payment positions. In 1925, the sterling was over valued against the dollar by nearly 44% and necessitated a devaluation. This devaluation had an impact on other currencies too and led to an exchange rate war.
England withdrew from the gold standard in 1931, America in 1933 and Italy, France, Belgium, Switzerland and Holland remained. It finally collapsed in 1936 with the devaluation of the French franc and the Swiss franc.
The Gold Exchange Standard - 1944-1970
During the second world war, international trade suffered with runaway inflation and devaluation of currencies. A need was felt to bring out a new monetary system that would be stable and conducive to international trade. The process was started in 1943 by Britain and the US and finally in July 1944 the American proposal was accepted at the Bretton Woods conference. The new system aimed to bring about convertibility of all currencies, eliminate exchange controls and establish an international monetary system with stable exchange rates. The IMF was set up in 1946 under the Bretton Woods agreement and the new exchange rate system also came to be known as the Bretton Woods system.
Under the Bretton Woods system, member countries were required to fix parities of their currencies to gold or the US dollar and ensure that rates did not fluctuate beyond 1% of the level fixed. It was also agreed that no country would effect a change in the parity without the prior approval of the IMF.
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