The History of Currency Exchange Rates
The history of currency exchange and how it works is a long tangle and is bound up in why money is worth anything in the first place. Even ancient coins, made out of gold and silver, could make exchange a thorny issue because those coins could be debased, carrying less precious metal content than their makers claimed it did. In the long run, money based on precious metals proved excruciatingly difficult for a government to maintain when it was placed under financial pressure and was abandoned in favor of the modern system of flat currency and its market-driven exchange rates.
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Precious Metal Coins
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Coins originated first in China in the 10th century BC. In the west, the origin of coins is attributed to the Anatolian kingdom of Lydia in the 7th century, as described by the historian Herodotus and backed up by modern archaeological work. Although more than two centuries separate the invention of coins in China and Lydia, it is believed they were developed independently, and the Lydian system of coinage is the one which was adopted throughout the West and continues to influence modern money. The Chinese system was based on bronze tokens, while the Lydian coins were made of electrum, a gold and silver alloy. This use of precious metals for general purpose transactions began the coin monetary system in which the value of a coin was, in theory, based firmly on the value of its precious metal content.
Coin Exchange
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Just as the precious metals in a coin determined its value at home, so it determined its value abroad. In practice, however, it could be difficult to determine the actual precious metal content of a coin. Archimedes famously discovered the science of displacement trying to deduce just how much gold was in his lord's golden jewelry, and the same problem applied to coins. An easy way to expand a money supply based on precious metal coins is to debase the coins, or dilute their precious metal content. This could severely impact on a coin's convertability and value. The Athenian silver tetradrachm, for example, was enormously popular throughout the Greek world and the Eastern Mediterranean from the 6th century to the 1st century BC because it earned a reputation for being made out of pure, high-quality silver.
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The Gold Standard
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While paper certificates carrying a stated value in gold had been used before, paper money as such did not become standard until 19th century Britain. The Bank of England began issuing banknotes in the 1830s, and these became the legal standard for money in Britain under the Bank Charter Act of 1844. This was the first practical Gold Standard monetary system in which paper notes backed by gold were issued as currency. Exchange rates were easy to calculate under such a system. If an ounce of gold worth $20 dollars in country A but 40 pesos in country B, then an exchange rate could be readily set at 1 dollar to 2 pesos.
Abandonment of Gold
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The problem with the gold standard was it was hard to maintain when a government was placed under extreme financial stress. Britain, the founder of the standard, regularly abandoned it and suspended the convertability of its banknotes to gold during times of war, only to resume the Gold Standard once it was again at peace. The last effort at making the Gold Standard work was the post-World War II Bretton Woods regime (Routledge Encyclopedia of International Political Economy, Benjamin J. Cohen). The U.S. government pledged to maintain a gold-backed currency of $35 to an ounce of gold, and other governments pegged the values of their currency to the dollar. Under this system, other currencies backed by gold were convertible as if the Gold Standard was still in force. Currencies pegged to the dollar were convertible based on their relative value vis-a-vis the dollar. If country A was pegged at 2 marks to the dollar and country B was pegged at 8 dinars to the dollar, then they knew 1 mark should be worth roughly 4 dinars. President Richard Nixon, under the combined stresses of paying for the Vietnam War and former-President Lyndon Johnson's Great Society programs, plus the policy of the French government to convert most of its dollar holdings into gold (thereby diminishing U.S. gold reserves), was forced to abandon the Bretton Woods regime in 1971.
Fiat Currency
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What replaced Bretton Woods and the Gold Standard was fiat currency. Under this system, money has value because the government issuing that money says it does. However, the actual value of that money in a currency exchange is determined on the foreign exchange market, not by government decree. Banks, governments and speculators buy and sell currencies to meet their investment, debt and trading needs, and the demand for a given currency determines its value. Factors that influence foreign exchange rates are the health of a country's economy, its government's fiscal policies, its level of indebtedness and the health of its financial system. For example, beset by poor economic performance, a banking crisis, systematically high deficits and a crisis of confidence in government leadership, the dollar generally performed poorly against other Western currencies between 2007 and 2009. At times, the U.S. dollar even slumped to being worth less than the Canadian dollar, a truly rare and humiliating event.
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