The word “money” has not always meant what it means today. Today when we use the word “money” we refer to “currency”. Both, money as well as currency used to mean very different things until about a couple of centuries ago. Prior to the monetary system that we have today, the world was on a monetary system which was called the “gold standard”. Therefore, to understand where we are today, we need to understand where we came from. This article will explain the gold standard and how it led to the modern world of freely floating currencies.
The Old Times
Trade has existed for many centuries prior to the existence of the modern world. In almost all civilizations of the world where trade happened, the concept of money evolved. The evolution of the concept of money finally led them to settle on some kind of commodity that could be used as money. In almost all civilizations, people chose gold and silver to be the money. The reasons for this are many and varied and beyond the scope of this article.
For us, it is important to know and understand that all trade that happened during the 17th century or so happened only when gold changed hands. Gold was therefore the global currency in existence. It was recognized and used worldwide. An approximate close comparison today would be the US Dollar which is recognized and used everywhere.
There was some sort of paper money being used in the 18th and 19th century when trade expanded a lot and it was difficult to carry around so much gold. However, the paper money being used was only a receipt for the gold. It was not money in itself. It was a representation, a receipt for money!
This monetary system wherein the prices of everything in the economy were fixed by gold is known as the gold standard. Some economists argue that it was probably the best way to manage an economy.
Gold Exchange Rates
Gold functioned as an efficient medium of exchange on the individual level as it did on the national level as well. The prices of all the currencies were fixed in terms of their weight in gold. For instance, if the French frank was worth 1 ounce of gold and the British pound was worth 1.2 ounces of gold, then the de-facto exchange rate between these two currencies can simply be worked out mathematically. Under the gold standard, the name of currencies signified the promise of the governments or private parties to give out a pre-determined weight of gold.
The gold standard was very efficient in multiple ways. One of the ways it promoted efficiency was that it did not allow for imbalances to grow in the market. For instance, if there was foreign trade between two currencies and one was importing a lot from the other, then the importing country would have to pay out a lot of gold to the other.
The falling amount of gold in the importing country would create a situation of deflation and the prices would automatically fall making its internal prices lower and therefore making the imports look expensive.
Similarly, the exporting country will witness a huge inflow of gold. Increased gold in the money supply will lead to inflation and therefore the prices of goods will increase making the exports expensive. The gold standard would therefore automatically prohibit an unhealthy trade imbalance between the two countries.
Other benefits of the gold standard include the fact that the government cannot manipulate the money supply to meet its own requirements. The money supply is fixed by the amount of gold that there is in the system. Hence, as long as the amount of gold in the system remains fixed, so does the money supply and the level of prices!
The gold standard was prevalent in the world in one form or the other till 1970. It had been replaced and renewed many times. However, it was still present until the 1970�s. In 1971, President Richard Nixon of the United States closed what is called the gold window. Thus, he effectively took the world off the gold standard. This meant that currency notes which were earlier redeemable for a fixed weight of gold, now could not be redeemed and were now to be considered valuable themselves. This event is known as the Nixon shock since such a bold move had not been anticipated by the entire world and sent shockwaves in the global economic system.
Freely Floating Currencies
When President Nixon took the world of the gold standard, all the currencies of the world suddenly had no backing in gold. This meant that the exchange rate between them could not simply be calculated using arithmetic! Rather the value of a currency now depended on a variety of factors. A lot of these factors were under the control of governments.
Hence, there was a need for a market where the exchange rates will be determined on a real-time basis based on the information flowing through the markets. Since the Forex market was where currencies have always been exchanged, it was well poised to take up this role.
The Forex market, therefore, came into prominence when the world went off the gold standard. This is because, during the gold standard, there were no exchange rates to determine! It is only after gold was removed as the common denominator between currencies that all of them became freely floating and there was a need to value them against one another.