Development of International Monetary System
Though each country has its own form of currency, the collectively traded currency of the world follows the international monetary system. The international monetary system is a set of rules agreed upon by countries internationally in order to set monetary standards for trade between countries. Prior to World War I, all currency was compared to gold using the gold standard, or the establishment of gold as the underlying asset for all currency minted in a country. To convert from a domestic currency to a foreign currency, the domestic currency would first be converted to gold, and then the gold would be converted to the foreign currency. Because of shortages of gold after two world wars and the increasing availability of technological aids, currency is now converted directly between two nations using an established currency exchange rate. A currency exchange rate is the relative ratio of the value of a foreign currency to that of a domestic currency.
The transition away from the gold standard was made in 1944, when nations met at the United Nations Monetary and Financial Conference and redefined the way in which currency was traded. The Bretton Woods system established at the conference made the asset that backs national currencies either gold or the U.S. dollar. This made the U.S. dollar the "world's currency." The U.S. dollar is considered fiat money, a note that a government establishes, and backs the value of, as a valid form of payment by law. U.S. currency became fiat money in 1971.
In 1971 the United States stopped converting the dollar directly to gold, which eliminated the Bretton Woods arrangement. Because foreign currency exchange markets had increased in power and usage, by 1973 a modern exchange system took its place. Thus, in 1971 the United States declared the U.S. dollar a fiat currency that was directly correlated to the dollar being removed from the gold standard which allowed the dollar to float on open exchanges.
At the beginning of the 2000s, Europe underwent a sweeping change to its economy. In order to decrease currency fluctuations between countries and to promote trade, several European countries created a treaty to establish the euro area. They also established one currency: the euro. The euro is a currency used by the eurozone members of the European Union, a combination of European countries agreeing to one economic standard. A eurozone member is one of the current member countries of the European Union that have agreed to use the euro as their currency. This agreement assigned a single currency standard against which nonmember countries throughout the world would exchange.A relatively new development in the international monetary system is cryptocurrency, a form of electronic currency that is not issued by a central bank. The best-known and most-traded cryptocurrency is Bitcoin. Since its development in 2009, Bitcoin is still considered new and unsupported; it is not backed by assets nor given regulatory oversight.
Development of International Currency Exchanges
Factors That Affect Currency Exchange Rates
Supply and Demand for Foreign Currency Markets
The World Bank is an international organization, developed from the Bretton Woods agreement, devoted to providing financing and advice to developing nations. The World Bank constructs a comparison of purchasing power parity across countries every three years. The International Monetary Fund uses the World Bank's comparison for loans and analysis. The International Monetary Fund (IMF) is an organization consisting of approximately 190 countries that makes loans to developing countries or organizations within those countries in order to combat poverty. For example, in 2017 the IMF loaned 78 billion of its standard funds, listed as SDR, to Mexico, Colombia, and Egypt to assist in stabilizing their economies.
Because countries use currency supplies to change inflationary direction, political risks and economic risks are inherent in currency exchange. A political risk is generally associated with a change in the political landscape of a country. A political risk is the danger that shifts in government and political policies will unfavorably affect the currency exchange ratio at the time of the transaction. In the United States every four years there is a lag in investment trading as investors weigh political risks associated with the presidential elections. Economic risk is the danger that shifts in the economy will unfavorably affect the currency exchange ratio at the time of the transaction, resulting in real economic loss. This type of risk is less complicated and often occurs because policies have been put into place that affect the strength, or purchasing power, of currency.