HISTORY OF FOREIGN EXCHANGE MARKET

At the end of World War II, the major countries of the world set up the International Monetary Fund (IMF). The IMF is an international organization that monitors balance of payments and exchange rate activities. In July 1944, at Bretton Woods, New Hampshire, 44 countries signed the Articles of Agreement of the IMF. At the centerpiece of those agreements was the establishment of a worldwide system of fixed exchange rates between countries. The anchor for this fixed exchange rate system was gold. One-ounce of gold was defined to be worth 35 U.S. dollars. All other currencies were pegged to the U.S. dollar at a fixed exchange rate. For example the Japanese’s Yen was set at 360 yen to a dollar, the British Pound was set at $ 4.80.

Although the fixed exchange system served well during the 1950 and early 1960, it came under increasing strain in the late 1960s and by 1971 the order was almost collapsed. Most economists trace the break up of the fixed exchange rate system to the US macroeconomic policy package of 1965-68 to finance both the Vietnam conflict and its welfare programs, President Johnson backed an increase in US government spending that was not financed by an increase in taxes. Instead, it was financed by an increase in money supply, which in turn, led to rise in price inflation from less then 4 percent in 1966 to close to 9 percent by 1968. With more money in their pockets the American spent more, particularly on imports, from here the US trade balance started to deteriorate rapidly.

The rise in inflation and the worsening of US trade position gave support to the speculation in the foreign exchange market that the dollar would be devalued. Things came to a head on spring 1971, when US trade figures were released, which showed that for the first time since 1945, the United States was importing more then it was exporting. This set off the massive purchases of deutsche marks by the speculators who guessed that the DM would revalue against the dollar. On a single day May, 4, 1971 the Bundesbank had to buy $ 1 billion to hold the dollar/DM rate at its fixed exchange rate given the great demand for DMs. On the morning of May 5, the Bundesbank purchased another $ 1 billion during the first hour of trading. At that point, the Bundesbank faced the inevitable and allowed its currency to float.