In the past, the value of goods and services were expressed in terms of other goods. This exchange system was called the barter system. The first coins to be used as a medium of exchange were made from gold and silver. Later on, during the Middle Ages, people began to use paper money to exchange value as an I.O.U. However, the foreign exchange industry itself is the newest of the financial markets.
During the last century, the foreign exchange market has undergone some dramatic transformations.
Prior to WWI, central banks supported their currencies through convertibility to gold. Paper money could be converted into gold on request to the bank. Since it was not likely that all holders of paper money would request gold at the same time, banks only needed to keep a determined amount of gold on hand in order to handle normal exchange requests (gold reserves). And so, the amount of money outstanding was increased relative to the amount of actual gold the bank has on hand. As a result, during times of crisis, when the confidence of the financial system was low, Banks experienced a “run on the bank.” This was when a large amount of currency holders requested conversion into gold at the same time, especially if it was more gold than the bank had on hand.
In 1944, foreign exchange controls were introduced in a bid to control the forces of supply and demand, with the intention of structuring the world economic system in a way that would stabilize the volatile foreign exchange markets. And so in July 1944, towards the end of WWII, the Allied countries (U.S., Great Britain, and France) met at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire and established the postwar foreign exchange system.
The Bretton Woods conference determined a system for pegging currencies and created the International Monetary Fund. The Accord fixed the US Dollar at $35 per ounce of gold and fixed other currencies to the dollar.
During the 1960s, the volatility between different country economies became more extreme, making it difficult for some to maintain the pegging system.
The Bretton Woods control system collapsed in 1971, when President Nixon suspended the gold convertibility standard. The dollar had lost its attraction as the sole international currency due to the impact of growing trade deficits and government budget deficits. During the 70’s, the European community tried to move away from their dependency on the dollar. The European Joint Float was established by West Germany, France, Italy, the Netherlands, Belgium and Luxemburg and in 1979, the free-floating system was officially mandated.