Before the times of the foreign exchange market, the world depended on the gold standard to determine the value of goods and services. This paper will describe in more detail the gold standard, the positive and negative aspects of using the gold standard and in addition the paper will summarize the major functions of the world’s major foreign exchange markets.
The gold standard was a monetary system that many countries used in order to determine the value of domestic currencies in relation to a specific amount of gold. The value of money, bank deposit and notes were transformed into gold at the specific amount. Britain was the first country to adopt the gold standard in 1816, followed by the United States. From 1834 until 1933 the specified price of gold in the United States was $20.67 per ounce (Bordo, 2002). However, in 1933 U.S. President Franklin D. Roosevelt put an end to the gold standard when he prohibited the possession of gold by any persons except for the purposes of owning or manufacturing jewelry (Moffatt, 2008). This was the beginning of the Bretton Woods System. Under the Bretton Woods System, countries agreed to settle their international balances by converting deficits into U.S. dollars at a flat exchange rate of $35 per ounce (Bordo, 2002). This monetary system only lasted until 1971 when President Richard Nixon completely ended the trading of gold (Moffatt, 2008). Since that time the gold standard has not been used by any major economies.
The most important benefit of using the gold standard was that it insured a low level of inflation. According to Michael Bordo (2002), “Whatever other problems there were with the gold standard, persistent inflation was not one of them. Between 1880 and 1914, the period when the United States was on the "classical gold standard," inflation averaged only 0.1 percent per year.” Inflation however is caused by four major factors:
1. The supply of domestic money increases.
2. The supply of merchandise decreases.
3. The demand for domestic money decreases.
4. The demand for merchandise increases.
Any combination of these four factors determines what the rate of inflation is. Therefore, as long as the supply and demand for gold did not change too quickly, the supply of currency remained stable.
The gold standard hindered countries from printing and distributing an overabundance of currency. When the supply of currency increases too quickly people want to trade currency for gold because gold has become in short supply where currency has become more abundant. For the reason that the gold standard set a system of fixed exchange rates, the only real currency throughout the countries that used it was gold.
The gold standard caused the foreign exchange market to remain relatively stable and is seen as one of the major benefits of the system; however it is the stability that the gold standard caused that is seen as one of the largest disadvantages also. Considering that the exchange rates were...