Introduction to Forex

  • Jun 27 2022
  • by
  • Analyst AZA
Introduction to Forex

Introduction to Forex Trading

The term «money» has had different meanings throughout history. In the modern day, when we use the term «money» we refer to «currency». Both, currency as well as money used to mean different things until some centuries ago. Before the monetary system that is presently used, the globe was on a monetary system that was referred to as the «gold standard». To understand how we got here, we need to know the historical events. This article attempts to discuss the gold standard and how the regime's freely floating currencies came about. Trade has been in existence for many centuries, before the existence of the modern world. In most of the societies around the world where trade took place, the was an evolution of the concept of money. This evolution eventually led them to settle on some kind of commodity that could be utilized as money.

In almost all societies around the globe, people preferred silver and gold to serve as the medium of exchange. This was a result of many different reasons beyond the scope of this article. For us, it is very significant to have awareness and understand that all trade that took place during the 17th century, occurred only when gold was transferred from one hand to another. Therefore, gold served as the world currency in existence, it was recognized and utilized around the world and a close comparison today would be the United States Dollar which is recognized and used everywhere. There was some kind of paper money that was used in the eighteenth and nineteenth centuries when there was a large expansion in trade and it was a hard task to transport around large amounts of gold. Although, the paper money that was utilized was a receipt for the gold and not money in itself. It was a representation, a receipt for the money.

The transitioning of the world monetary system from the gold standard to the free-floating Forex markets was implemented without a glitch. Countries around the globe worked together to make two factions that would serve as a foundation of the present monetary system. Although, both the arrangements failed. In this article, we will take a microscopic view of those arrangements. The situation in Europe was that the European nations had been in a gruesome world war two. Therefore, the economies of the countries had been severely damaged. Most of the nations had tried to adapt by increasing the money supply to be able to fund the expenses caused by the war. Therefore, most economies felt threatened that as soon as the war ended, most economies in the Euro area would implode due to the inherent imbalances in their foreign exchange markets.

To stop such a scenario from taking place, political leaders and economists around the world, held a meeting at a place called Bretton Woods which is situated in the United States. This is referred to as the Bretton Woods conference and has had a big influence on the monetary system and the evolution of the currency markets. The goal of the meeting was to provide a new monetary system that could be able to absorb future shocks that were to be received once the war was over. The conference was conducted to create a system that would make it possible for nations to avoid steep depreciation of their currency systems. The arrangement that was concluded in the meeting was more complex relative to the gold standard that was previously used. Before the conference, the dollar was pegged to gold.

The US was known to possess the largest reserves of gold post-world War two. According to many sources, it owned more gold than all the European countries combined. This is the reason the dollar overtook the pound as the most significant currency during the time. Provided the United States possessed most of the gold in the world, the value of the US dollar was fixed to gold. The price was fixed at thirty-five dollars per ounce of gold. A time was made, when anyone having ownership of a dollar bill could exchange it for gold. Since the dollar was perceived as the most valuable and stable currency in the world, many international currencies were pegged to the dollar. For example, if the value of the dollar appreciated by five percent, the price of the other currencies would also appreciate by five percent only. The pegs were allowed to have a one percent differential in price.

If a currency fluctuation were greater or lower than one percent of the value of the dollar, the Central Banks would be required to participate in open market operations where they would buy or sell their currencies to bring the peg to the appropriate trading range. The Bretton Woods system eventually resulted in making the dollar the reserve currency of choice for most countries around the world. Since most the nations were now conducting business in US dollars rather than gold, most commodities such as gold and oil were priced in terms of US dollars rather than gold. As a result, the dollar became a reserve currency. This means that if a country wanted to execute transactions in foreign trade, it had to have a certain amount of dollars in ownership, even when they are not trading with the United States. International economic institutions that are present today were created as a result of the Bretton Woods conference.

Global entities like the International Monetary Fund and the World Bank were given birth as a result of this agreement. The Bretton Woods agreement was one of the most famous arrangements among countries to maintain a formal and stable monetary system. Although, it only survived for twenty-seven years, until 1971. The Bretton Woods system officially ended after president Nixon unilaterally took the United States off the gold standard and automatically took the world off the gold standard since most currencies were pegged to the dollar. The president of the United States at the time, Richard Nixon removed the world from the gold standard in 1971, but he was worried that free-market operations in the Forex markets would bring devaluation and destabilize many currencies. As a solution, he advised countries to agree called the Smithsonian agreement.

This agreement was a failure because it was in use for a couple of years and caused the complete suspension of the Foreign Exchange markets. The United States pleaded with the G-ten nations to participate in an agreement in which they would let their exchange rates be pegged to the dollar but the dollar would not be fixed to gold. Therefore, the agreement was similar to the previous one minus the gold backing. The agreement also increased the fluctuation rate from one percent to two and a half percent before the Central Banks considered conducting open market operations. This agreement seemed very weak on paper but it was destroyed after it was tested in the real world. The trade deficit in the US kept increasing, and as a result, the value of gold went up significantly higher in 1972. Therefore, all the members of the G-10 dumped the Smithsonian agreement.

This ended up in the suspension of the Foreign exchange markets for some time. The inability of the economies of the world to structure a system where the rates of the currencies would be fixed to something and maintain stability left no other option other than having a market for freely floating currencies. The Forex market as we know it today is the result of the failure of the Bretton Woods and the Smithsonian agreement.

The transitioning of the world monetary system from the gold standard to the free-floating Forex markets was implemented without a glitch.


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