Different countries have adopted different exchange rate systems at different times. The following are some of such systems in brief
Gold Bullion
In modern times, the operative system of exchange rates has evolved from a gold bullion standard to a system of floating exchange rates with several alternative systems used in between.
The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. Under this system, central governments defined their currencies in terms of a specific amount of gold bullion and agreed to redeem their currencies at the set rates (mint parities). However, as a commodity, the international market price of a currency (the exchange rate) would fluctuate above or below parity based on the supply and demand of that currency relative to others. If excessive demand forced the market price of a currency above the parity band, external debtors found it cheaper to pay their debts in gold. Conversely, if insufficient demand for a currency lowered its market price below the parity band, external creditors demanded payments in gold.
Under this system, unless a country maintained a reasonable trade balance over time, continuing trade deficits would drain its gold reserves. The lower level of gold reserves would, in turn, result in shrinkage of that country’s money supply and a lower internal price level. Lower domestic prices would eventually make the country’s products more competitive in the international marketplace. As exports increased, the demand for the country’s currency would also increase resulting in an inflow of gold reserves. With a self-balancing system such as this, the governments’ role was a passive one in which they would merely permit the free flow of gold to stabilize economies and exchange rates. Thus, the gold bullion standard acted as an automatic stabilizer, at least in theory.
The Gold Standard
Many countries had accepted the Gold Standard as their monetary system during the last two decades of the nineteenth century. Under this system, the parities of currencies were fixed in terms of gold. The currencies of the countries, which were on gold standards, could be exchanged freely and the rate varied depending upon the gold content of the currencies. This was also known as the Mint Parity Theory of exchange rates.
Gold Standard helped in maintaining the stability in exchange rates and correcting the disequilibria in their balance of payments on an automatic basis. This system was in vogue till the outbreak of World War I. Several efforts went futile in reviving this system and the era of Gold Standard came to an end by late 1930s.
Bretton Woods System
During the world wars, economies of almost all the countries suffered. In order to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War II, the United States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to the financial chaos that had reigned before and during the war.
In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the “custodian” of the system.
