The exchange rate history of the nineteenth century highlights the importance of the gold standard in that era. From 1876 to 1913, the exchange rate system was dependent on the respective currency’s comparative convertibility to an ounce of gold. However, this method of determination of the exchange rate had to be reassessed when the gold standard was suspended during World War I.
Exchange Rate History: 1914 - 1944
The suspension of the gold standard in 1914 was followed by a collapse of the exchange rate market. In the early 1920s, some countries tried to revive the gold standard to get the old exchange system back into practice. However, the Great Depression hit the United States in 1929. The devastating effects of this were felt by most of the developed world. As a result, all plans on the revision of the gold standard were abandoned.
Close to the end of World War II, the Bretton Woods Agreement was signed. Since the impact of the Great Depression was still fresh in the minds of the policymakers, they wanted to shun all possibilities of a similar fiasco. The Bretton Woods Agreement founded a system of fixed exchange rates in which the currencies of all countries were pegged to the US dollar, which in turn was based on the gold standard.
Exchange Rate History: 1944 - 1971
The Bretton Woods Agreement was in effect till 1971. By 1970, the existing exchange rate system was already under threat. The Nixon-led US government suspended the convertibility of the national currency into gold. The supply of the US dollar had exceeded its demand. In 1971, the Smithsonian Agreement was signed. For the first time in exchange rate history, the market forces of supply and demand began to determine the exchange rate.
Exchange Rate History: The Floating System
The Smithsonian Agreement did not last very long. By 1973, the extensively traded currencies were permitted to fluctuate. In a floating currency system, a currency’s value is allowed to vary in keeping with the conditions of the foreign exchange market.
The advantage of a floating exchange rate system is that it is self attuned. A floating currency system allows greater liquidity and central bank control, but can be subject to attacks by speculators, or sudden panic-driven moves by investors that lead to currency crises and recessions.