What is an exchange rate? An exchange rate is the rate at which one currency is exchanged on another one. Exchange rates can differ from country to country. The main variables that affect exchange rates are the general balance of the economy, monetary and fiscal policies, the state of the budget, international policy, the purchasing power of the currency, and other internal and external factors. As we look at the world exchange rate as a whole it shows us that the world community as majority has in fact shifted from a system of fixed exchange rates to floating exchange rates. Currently there exist different combinations of floating and fixed exchange rate systems, together with specific economical instruments, created for the regulation of exchange rates.
For centuries all the currencies of the world community were backed by gold. Which means that government would issue paper money that represented an amount of gold held in a vault that was regulated by the government. Therefore, the exchange rate between different countries was equal to the ratio of gold linked with the currencies. This system is an example of the fixed rate system that existed until 1913. Things didn’t really start to change until the United States set their dollar at a steady level; 1 ounce of gold was equal to thirty-five dollars. Therefore, none of the countries offered 100% backing for their currency so the demand and the purchasing power of a particular currency depended on the credibility of the currency. So a country that had a slow economical development was less credible, and the faster developing countries were more creditable. Countries were trying to improve their economical condition by trying increase the purchasing power of their currency and decrease the purchasing power of other countries currency. So, the economies of the countries with less credible currency worsened. This situation shows one of the weaknesses of a fixed exchange rate system.
Since currencies have become less depended on gold the main variable that defined the purchasing power of a currency was the credibility of it. Therefore, economical crisis created instability in currency exchange rates. Until the 1940s the world community had undertaken attempts to return to the gold standard, but none were successful. A new system wasn’t adopted until after WWII. The new system of exchange rates was based not off gold, but off the US dollar. This system strengthened the United States position as a dominating economy and it affected the exchange rates of countries with weaker economies. Since the worth of the U.S. dollar was widely known the value of other currencies could be based off its value in gold. So a currency that was worth twice as much in gold as the U.S dollar would be worth two U.S. dollars. The International Monetary Fund (IMF) was made to help create a balance. Countries with weaker economies were given loans to help improve their economical state. But the huge gap between the stability of the exchange rates of dominating countries and the exchange rates of other countries proved that existing exchange rate needed to be improved. From that need for improvement three new exchange rate systems appeared the fixed exchange rate system, the floating (or flexible) exchange rate system, and the managed exchange rate system, which combined both above-listed systems. The fixed rate system existed until 1973 but in 1971 the switch to a floating change rate system began. In 1971 he US dollar became significantly overvalued against other currencies and since the US government did nothing to try and protect the value of the dollars a floating rate based on the dollar’s exchange rate started. In 1973 the world community tried to revert back to a fixed system but it didn’t have any effect because other currencies were already so strongly linked to dollar value.
It is shown throughout history that the US supports the idea of a self-adjusting market. Which means that the US