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Many people would ask how and why a currency increases or decreases in value, the effects are to be considered when looking at gold standard. Money, although often thought of as only a medium of exchange, has a value of its own and is also a commodity, in the same way as oil, gold, silver, or corn are commodities (Feiler, Schilling). The price of money as a commodity is often determined or set as a result of government action and international trade. Value is determination by the foreign exchange markets of the world. The foreign exchange rates have a lot to do with it as well for example; Exchange rates respond directly to all sorts of events, both tangible and psychological—business cycles; balance of payment statistics; political developments; new tax laws; stock market news; inflationary expectations; international investment patterns; and government and central bank policies among others.( Federal At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall. (Federal Bank of New York) Foreign exchange trades can occur in a stock market, similar to the Chicago Board of Trade. Normally it is the major banks in each major nation, such as the Bank of London, the Federal Reserve Bank of New York, and the Bank of Tokyo, which help exchange one currency for another and through their purchases of currency “reserves” help set the “price” of all currencies.
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This system where the prices of currencies are allowed to fluctuate is a “floating exchange rate” system (FRB New York). This floating system, although it may seem to make sense given how common international trade has become in the modern world, was not the standard use until the very last decades of the Twentieth Century (FRB New York). Prior to the floating exchange rate system the world used was the “gold standard” (FRB New York). Under the gold standard nations’ central banks would determine the value of their currency based on how many ounces of gold each one unit of their currency could purchase (Bordo). Other nations did the same, so that all currencies had a value that could be compared against a common denominator – gold. Gold could be held and seen and its value has been known for centuries, a currency exchange set up with gold as its base could be trusted by members of all nations who knew that if they arrived at the Bank of London with U.S. Dollars they would receive British pounds in an amount equal to how many ounces of gold they could acquire in England.
This gold standard system was not only stable but it also had the trust of all nations. Gold has had a long history of value and its value is very easy for average citizens to understand and trust (van Eeden). The use of a gold standard also helped currencies remain fairly constant in value as re-pricing of currencies, against gold, was rarely done (FRB New York). However, there were problems with the gold standard as time passed.
First, gold costs money to produce, which the gold standard did not account for (Bordo). This fact meant that every time a nation produced gold or bought it, it was spending more to acquire it or store it then it was using to value its currency (Bordo). The end of the gold standard came about because the gold standard became too difficult to maintain (FRB New York). One example was the United States began to import more and more goods from abroad, foreign holdings of U.S. Dollars caused great concern that the U.S. simply did not have enough gold reserves to redeem such dollars (FRB New York). It was for this reason that President Nixon in 1971 announced the United States would no longer redeem U.S. Dollars for gold (FRB New York). It was at this point, when the U.S. Dollar was no longer pegged to the price of gold. Other currencies then began to value their currencies solely to the U.S. Dollar (FRB New York).
Foreign exchanges markets help keep the system of floating exchange rates functioning. As international business increased, especially during the last quarter of the Twentieth Century, companies around the world needed a reliable means of trading their native currencies for goods and services from across the globe. To do this, businesses had to be able to pay for goods in services in a currency which businesses from outside their country that they would accept (Feiler, Schilling). In addition, business owners also wanted a way to store their profits in currencies which would retain their value, especially if their national currency’s value fluctuated wildly (Feiler, Schilling). To meet the needs of all of the market participants that was when the foreign exchange markets came into existence (FRB New York).
Foreign exchange markets, through the use of national banks help establish a firm trading value for a currency (Feiler, Schilling). They help business conduct international transactions because they provide such businesses a place to trade foreign currencies in a place where they can learn the value of international currencies in order to appropriately set business prices (Feiler, Schilling). Foreign exchange markets also help value their own national currencies through their market actions (FRB New York). They may act to purchase or sell large amounts of their own currency in order to keep their currency’s value high or low to match government economic needs (FRB New York). Foreign exchange markets and the others act as international ATMs, currency converters, currency holders, and currency markets to allow international businesses and banks to easily come to understandings regarding the value of goods and services and the price that should be placed on them.
Bordo, M.D. (NA). Gold Standard. The Concise Encyclopedia of Economics, The Library of Economics and Liberty. Retrieved September 21, 2008, from http://www.econlib.org/library/Enc/GoldStandard.html
Federal Reserve Bank of New York. (NA). The Basics of Foreign Trade and Exchange. Retrieved September 21, 2008, from http://www.ny.frb.org/education/fx/print.html
van Eeden, P. (2005). The History of Money. Retrieved September 21, 2008, from http://www.kitco.com/weekly/paulvaneeden/nov182005.html