Gold Standard and Functions of Foreign Exchange Markets
All across America there are more than 48 million household members, small investors who are investing money in foreign exchange and capital markets. 11 millions of all of them are working online so that they can make prompt decision regarding their investments. Exporters, banks, travelers, importers etc all follow the forex exchange rates closely as it has significant impact on the business. Understanding the Evolution of Gold Standards and its Limitations The gold standard was first started in 1820’s in England when gold replaced silver as the principle commodity.
The next fifty years were known as early globalization years in the history of human civilization as trade among countries increased tremendously. To manage the increasing trade most countries with stable government realized the value of having a paper currency which is backed by the gold reserve with them. Under this the country can only print as much money has it have in gold reserve. This is a sort of promise to people and other nations that their paper holding can be exchanged into gold if a crisis occurs. (Britannica, 2008)
By 1870’s all the major nations – United Kingdom, France, Germany, and United States have adopted the Gold Standard. This was also due to the increased gold supply in international market as large reserves were discovered in United States and parts of Africa. The gold standard only lasted till the outbreak or World War I when most countries put a ban on exporting gold thus resulting in financial markets bottleneck. The reason for these bottlenecks was limited fluctuations of the currency determined by the cost of shipping and gold insuring.
Under the gold standard the gold can only fluctuate with in the fixed price limit usually known as ‘Mint Parity’. For example during the World War I, the mint parity based on the gold reserve between United Stated and United Kingdom was one pound Sterling equaling 4. 86 USD. Under this mechanism the exchange rate was limited to 3 cents above or below mint parity and nobody is willing to pay more or take less in the exchange rate. These 3 cents is determined by shipping cost and insurance of gold. (Britannica, 2008)
The biggest strength of the system also led to the downfall of it, it was first adopted to limit the power of governments and central banks to cause inflation and secondly to provide a stable system. With the outbreak of World War I the trust among various governments hit nadir and free flow of gold was curtailed due to strategic and political reasons leading to bottlenecks and payment failure. (Britannica, 2008) Number of other reasons which led to the fall of the gold standard were
- The Gold Standard was not flexible enough to answer the economic needs of the changing world. It constrained the supply of money essential for growth and economic expansion.
- Countries under this system failed to isolate themselves from global inflation and depression in other part of world.
- Payments processes were long and painful and thus slow to adjust with the employment rate and interest rate.
Modern Foreign Exchange Markets
Modern Financial markets are an extension of the barter system where goods were exchanged in lieu of goods, in modern day financial markets assets are exchanged for assets. Foreign exchange in modern world is an asset class where individuals can invest their money. The forex markets are based on the economic concept of ‘perfect competition’, where each buyer and seller is free to quote their price and ultimate price is determined by the demand and supply of respective currency. For example if one is uncertain about the economic condition of United States then he/she can prefer to buy Euro or Sterling if they believe that the economic prospect of pound and sterling is better compare to dollar. (Dicks, 2004)
The present mechanism is also known as ‘floating exchange rate’ mechanism as each currency is flexible to another. The forex markets officially shifted to the floating exchanging mechanism after the fall of Smithsonian agreement and European joint float. Today even though most of the currencies are free float but it is for countries to decide whether they like to free float, completely peg or semi peg.
Functions of the Foreign Exchange Markets
FOREX trading is not bound to any one trading floor and is not a market in the traditional sense because there is no central exchange. Instead, the entire market is run electronically, within a network of banks, continuously over a 24hour period. The major players of the foreign exchange markets are
- Retail customers for example exporters and importers who buy and sell foreign exchange.
- Foreign Exchange Dealers are commercial banks and financial institution which do the transactions either on behalf of their customers or to hedge international financial market risks.
- Forex Brokers – Brokers charge commission on transaction of forex. They can’t take open position and are usually specialize only in few currencies.
Finally the biggest players in the forex markets are the central banks which facilitate treasury transactions and take steps to stabilize their relative currencies or buy and sell based on the economic state of domestic economy. How Forex Market Functions In Forex markets currencies are traded in pairs, for example USD/EURO or USD/YEN. In this way one can trade any currency to any currency in the world but presently more than 80 percent of the transaction in these three pairings.
Before the emergence of Euro German Mark and Franc were also heavily traded currencies. Apart from the need for transaction bankers and dealers buy forex for hedging and currency stability purpose. For example if European bank want to keep EURO/USD at 1. 33 then it can buy dollars from the open market to boost up the rate. (Dicks, 2004) For hedging purpose one can get spot rates three months in advance based on leverage and premium formula. This will help the exporters and importers to hedge their revenue in view of volatility in the forex market.
Similarly options are also traded in market where future buying and selling is permitted. In the Forex future one can leverage 100 times the deposited money. For example in lieu of 1000 USD deposit a buyer can buy 100,000 worth currency future or can sell that much amount based on his/her future market potential. Conclusion The transition to free floating was expected to simplify the whole forex process but in reality it provided more complication. The perceived benefits of fundamental equilibrium value, international competitiveness and independence of monetary and fiscal policies were hard to come by.
In fact integration of world financial market has made each market more dependent on another. For example the recent meltdown in emerging markets is due to fears of American recession even in the face of strong domestic growth. (Obstfeld, 2004) The weakening of dollar compare to other currencies has reduced the profitability of exporting countries while Federal Reserve is unable to cut rates aggressively to one fearing of weakening dollar further and secondly financing inflation in the economy.
- Dicks, James. (2004) Forex Made Easy. Blacklick, OH, USA: McGraw-Hill Professional, 2004
- Britannica (2008) Gold-exchange standard. ” Encyclopaedia Britannica. 2008. Encyclopaedia Britannica Online. 25 Feb. 2008 http://search. eb. com/eb/article-9037216
- Obstfeld, Maurice (2004) Global Capital Markets: Integration, Crisis, and Growth. West Nyack, NY, USA: Cambridge University Press, 2004.