An ancient system. In ancient times the monetary system was fairly informal. It was comprised of moneychangers who worked with merchants operating in a given trading region. The moneychangers were illegal in some places, but where trade thrived, they were present. During the Roman Empire, the use of coin spread rapidly, in no small part because people needed money with which to pay their taxes, but also as an effect of the Empire’s economic integration. As Rome grew more powerful, and more people used its currency, the Empire looked quite like a trade bloc with a single currency.

Coins and paper in Medieval Europe. It wasn’t until the 13th century that gold coins, like those minted in Rome, were used across much of Western Europe. But by this point there were all kinds of gold coins: florins from Florence, sequins and ducats from Venice, and so on. Silver coins were also common in everyday use, as were copper coins. This heady mix of monies was the basis of international settlements. Coin would flow into nations who sold more than they bought or who borrowed more than they lent, and would flow out of countries that did the reverse. Paper currency—which were more like checks or IOUs, usually offered at a discount, representing a claim to a certain amount of precious metal—developed as moneychangers became lenders and depositories of precious metal, and people began to recognize the inconvenience of carrying around heavy metal coins.

Advent of the gold standard. In the late 19th century the gold standard really took hold in Europe and the United States. Its origins were in the Napoleonic wars earlier that century. At that time, the Bank of England printed lots of pound notes to finance war efforts; but that left the Bank and the British government in a sticky position: far more pound notes would be in circulation than the Bank could actually redeem in gold at the given price. Fearing a run on the Bank’s gold supplies—since the pound notes were no longer fully backed—they suspended the pound’s gold convertibility. But, as we might expect, these policies weakened the pound’s value, leading to higher prices and inflation. So after the wars, the men of Parliament (mostly landowners and merchants hurt by inflation) sought to prevent further erosion of their money’s value. They passed laws that made the pound fully convertible into gold at a specified rate. By 1821, England was on the gold standard; by 1880 most other nations had followed suit, and the international gold standard was officially in place.

Gold, along with silver, functioned as the international store of monetary value until the beginning of World War I. At that time, the gold standard was abandoned, primarily because nations needed deficit financing for the war, which increased the amount of paper money in circulation beyond nations’ gold reserves.

After WWI. After the war many countries let their currencies float (that is, fluctuate in value against each other and gold), but in looking forward to the return of the gold standard, tightened their monetary policies and supply of money in the 1920s. By doing this, central banks sought to strengthen their currencies so that when they went back on the gold standard, they could maintain the prewar currency-gold exchange rates. These “deflationary” policies—so named because they increased the value of currency, rather than decreasing it, as “inflationary” policies do—did strengthen currencies; but they did so at the cost of sending the economies of Europe and America into severe recession and contributing to the great depression. High interest rates, caused by a smaller supply of money in circulation, and increasing money values did mean lower prices; but lower prices were a disaster for businesses (individuals) who owed money: the value of their debts increased while the price of their goods (the value of their wages) decreased. Unemployment and bankruptcies soon followed.

To put it another way, the basic idea was that, after the War, nations began printing money to pay for the War. They soon had more of their money in circulation than they had in gold to back its value at the official “gold” price (they really had no choice given the War), so the gold standard fell apart. After the War, nations expected gold to return as the standard. Wanting their currency to be strong (worth lots of gold) they pursued policies to limit the amount of their money in circulation, which caused deflation (lowers prices and wages)—and lower prices can be a disaster for an economy. Why? If you own a business and prices are falling, covering your production costs will be nearly impossible. And if you have debt and your wages are falling, it will be nearly impossible pay it back. This is why there were so many business failures and foreclosures during the Great Depression.

	***Tip Box: Confused by inflation/deflation? Inflation means higher prices, which means your money doesn’t go as far and is consequently “worth” less. Deflation means lower prices, which means your money goes further and is consequently “worth” more. But if you incur a debt during a period of normal rates or inflation, and must pay it back during deflation, you have fewer dollars to pay back what you owe and consequently a greater chance of failing to pay your debts. Prices in an economy are basically a relationship between the amount of stuff an economy produces and the amount of money in circulation. For example, suppose your economy made 10 widgets and there were 10 dollars of money in circulation. The price of a widget would be 1 dollar (units of money / units of widgets). Now suppose that you decided try to make your economy richer by printing and additional 10 units of money, giving you a total of 20. In the long–run, the only effect such an increase in your money supply would have is to double the price of your widgets. In other words, printing money does not make you richer—it merely creates inflation, which makes the individual units of your money worth proportionally less. So how would you make your economy richer? Improve your productivity and make more widgets… (Sound familiar?)***

WEBSITE: For more detailed information on this period of the history of the exchange rates visit:

Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
Conflict & Cooperation (1871–1944)

Advent of the dollar standard. The initial return to the gold standard, then, was not a happy one. Indeed, some economists have suggested that the international community’s insistence on conformity to the old gold parities was a principle cause of the rise of German fascism and World WarII. So, after the war, when the world returned to gold, it did so under the auspices of the Bretton Woods agreements, which also established the World Bank and International Monetary Fund.

Essentially, these agreements put the world on a dollar standard, and the US on a gold standard. That is, currencies other than the dollar had to be maintained in a certain trading range with respect to it (the dollar), and the US agreed to change dollars for gold at $35 per ounce—for foreign central banks only, not the public. The IMF was the central bank for central bankers, providing foreign currencies to intervene in foreign exchange markets. But US monetary policy guided the international financial system.

WEBSITE: For more detailed information on this period of the history of the exchange rates visit:
Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
Destruction & Reconstruction (1945–1958)

The impact of the US’s role. This arrangement worked throughout postwar rebuilding and the emergence of Japan as an economic power into the late ’60s and ’70s, in part because most of the developed world was happy to follow the dictates of US monetary policy. That was true until the late 1950s, when the needs of the system grew as countries began to trade more freely. In the early ’70s, after the US had pursued inflationary monetary policy for a decade (to fund the Vietnam War and Lyndon B. Johnson’s Great Society programs), the primary contradiction in this system became evident. Since the world was on a dollar standard, US policy increasingly drove world economic growth. And for the world to grow, the US had either to lend more than it borrowed, or buy more than it sold abroad. There had to be an increase in the supply of dollars to the rest of the world. In other words, expansionary monetary policy—which stimulates growth—could only be provided by the US.

By definition, however, expanding the US money supply undermined the value of the dollar against all of the currencies that were pegged to it. So, to keep the dollar from depreciating, the Bretton Woods system required the world’s central banks to intervene in the foreign exchange markets and buy up dollars. Eventually, however, there were a lot more dollars floating around than the US Federal Reserve and Treasury could convert into gold at $35 an ounce. In 1973, with the world’s central banks—which had accumulated vast supplies of dollars—questioning the US’s commitment to buy back dollars for gold, the US ended dollar gold convertibility. And with the dollar no longer backed, central banks, naturally, stopped supporting its value, leaving exchange rates to freely float.

WEBSITE: For more detailed information on this period of the history of the exchange rates visit:
Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
The System in Crisis (1959–1971)

 

VIDEO: Money Used to be Backed by Gold, Now It’s Backed by God

 

The managed-floating currency system. Since then, the world has worked on the managed-floating currency system, which has had mixed results, but has been critical to international integration. The task in this era has been to stabilize this system, whose volatility increased markedly in the ’80s and ’90s, particularly among fragile developing nations, whose economies often flourished or fell on the success or failure of a single market. For this a number of things—often variations on the old fixed-rate system—have been tried: exchange rate and “crawling” rate pegs, currency boards, and dollarization, to name a few. It is difficult to generalize about the results, since these currency arrangements often stand or fall on other macroeconomic policies—and on the policies of the IMF. Suffice to say that, although theory tells us that free monetary and capital mobility might be optimal, the globalized world is still working to make the most out of second-best alternatives.

WEBSITES: For more detailed information on this period of the history of the exchange rates visit:

Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
Reinventing the System (1972–1981)

Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
Debt & Transition (1981–1989)

Money Matters: An IMF Exhibit—The Importance of Global Cooperation:
Globalization and Integration (1989–1999)