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The Gold Standard

Before money, there was bartering. Money eventually became a more efficient means of trade due to the fact that goods could not be easily divided, and could quickly lose their value, when a value could be determined and agreed upon (Morris 4). Alternately, money could have symbolic value and thus function as a medium for exchange or unit of accounting. Money in its original form consisted of something that was valuable itself such as valuable metals. The metal usually consisted of gold or silver (Eichengreen, 9), and was considered valuable because of both its sparsity and its obvious usefulness.

Both coins and paper money were being used by the nineteenth century. Currencies were not valued directly against each other but rather under a "Gold Standard". Under the gold standard each currency had a specific rate at which the same currency could be considered for a specific unit of gold. This however gave birth to a use full exchange rate between any two currencies.

To illustrate, in 1900 the mint parity for the U.S. dollar was $20.67, while the British equivalent was was 3 pounds, 17 shillings, 10 pence. If one wanted to exchange U.S. dollars for British pounds under the gold standard, one would divide $20.67 by 3.17.10, which yields a rate of $4.86 per pound after taking into account that U.S gold coins contain slightly more gold content than Brittish coins (Aliber, 34).

Following this logic, paper money could be used instead of some precious metal. A citizen could keep with them paper money while the central bank would, in which greater amounts of money exited the country than entered, that would lead o less U.S. dollars in circulation.

Since central banks have heavy influence when it comes to the interest rates (interest rate is a name for the rate at which the bank borrows and lends money), they soon discovered that it was no longer necessary to sit and wait for gold flows to be replenished. In the scenario of a gold deficit where gold is rapidly leaving the country, a central bank would be able to make investing with them more attractive by raising interest rates.
Floating Exchanges Systems

A floating exchange system values currencies in terms of other currencies not in terms of a gold standard.

Before this exchange system was in place, there were three aspects of previous systems that were in conflict: autonomous domestic economic policies, constant exchange rates, and increasing international capital mobility. The Bretton Woods agreement did not hinder or preclude countries from ignoring long term effects on the exchange rate by using domestic economic policy (manipulating interest rates, for example, as under the gold standard) for domestic reasons. The effect of domestic economic policies only happen sooner then expected due to capital mobility.

The Vietnam War brought about great instability causing, central banks to exchange their dollars to gold. To put an end to the loss of gold, in 1971 Nixon "closed the gold window" by not providing gold to foreign dollar holders under any circumstance (Eichengreen, 133). This lead to the Bretton Woods System of adjustable pegs officially being abandoned in 1974. With no binding agreements in place the Jamaica Agreement was reimplemented which allowed a country to choose any exchange system it wants (Aliber, 52).
Exchange Systems Today

Today countries can choose from a variety of exchange systems. A free floating exchange system, as mentioned earlier, permits the market to establish the price of a currency. Many factors such as domestic investments versus foreign investments, trade surpluses and deficits and domestic taxation policies, could affect the exchange rate, and would all be able to occur regardless of their effects on the currency.

A pegged exchange rate as in the Bretton agreement, would function much like the traditional way of the gold standard with its currency being linked to the rate of another currency, in most instances the U.S. dollar. If a balance of payments deficit exists, the central bank would then probably buy a specific amount of the domestic currency in return for its foreign currency reserves, thus bringing back the price of the currency to its "peg" but also at the same time depleting the amount of its currency available in its reserves.

Some countries manipulate their currency rates in order to help domestic needs (while maintaining their free-floating status) by boosting (revaluing) their exchange rate prior to an oil shipment, for example (Luca, 17). Other countries, such as Brazil, before changing to a free floating system, peg their currencies to that of the U.S. dollar or a different currency while permitting the rate to fluctuate within a certain range not unlike the Bretton Woods system.

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