Course Title: International Financial Management

Course Code: FIN-503

Submission Date: 01 December 2023

Submitted To:
Md. Alamgir Hossain
Associate Professor
Jahangirnagar University

Submitted By:
Montasif Manjur Rashid
ID: 202202017
Institute of Business Administration
Jahangirnagar University
The historical evolution of exchange rates is a complex and dynamic process influenced by a
variety of economic, political, and social factors. Understanding the evolution of exchange rates
involves examining key events, policies, and trends that have shaped the global monetary system.
Here's a broad overview of the historical evolution of exchange rates:
Gold Standard (19th Century - Early 20th Century):
During the Gold Standard era in the 19th century and the early 20th century, exchange rates
were fixed and directly tied to gold. The basic principle of the Gold Standard was that the value
of a country's currency was defined in terms of a specific quantity of gold. Here's how exchange
rates worked under the Gold Standard:
 Gold Backing:
Each country that adhered to the Gold Standard had its currency backed by a specific amount
of gold. For example, the United States might set the value of the dollar in terms of a certain
weight of gold, such as an ounce.
 Convertibility:
Currencies were freely convertible into gold at a fixed exchange rate. Holders of a country's
currency could exchange their notes or coins for the equivalent value in gold. This
convertibility provided a measure of stability to the currency.
 Fixed Exchange Rates:
Exchange rates between different currencies were essentially fixed because each currency had
a fixed value in terms of gold. The exchange rate between two Gold Standard countries was
determined by the ratio of their respective gold contents.
 Balance of Payments Adjustment:
The Gold Standard was designed to maintain balance in international trade. If a country
experienced a trade surplus, it would receive gold as payment. Conversely, a trade deficit
would lead to gold outflows. This gold movement acted as an automatic mechanism for
balancing trade.
 Price-Specie Flow Mechanism:
The process through which gold flowed between countries in response to trade imbalances was
known as the Price-Specie Flow Mechanism. Countries with trade surpluses would accumulate
gold, causing an increase in their money supply, leading to a rise in prices. Conversely,
countries with trade deficits would experience a decrease in the money supply and a decline in
prices.
 Global Stability:
 The Gold Standard aimed to provide stability to the global monetary system by linking
currencies to a tangible and universally valued asset (gold). This stability was intended to
facilitate international trade and investment.
 Challenges and Limitations:
While the Gold Standard provided stability, it also had limitations. Economic growth was
constrained by the fixed supply of gold, and countries faced challenges during periods of
economic stress, such as the inability to implement independent monetary policies to address
domestic issues.
Interwar Period (1914-1944):
The interwar period, spanning from the end of World War I in 1918 to the establishment of the
Bretton Woods system in 1944, was marked by significant economic and political upheavals.
During this time, the international monetary system experienced a shift away from the gold
standard toward more flexible exchange rate arrangements. Here are key aspects of the
exchange rate dynamics during the interwar period:
 Abandonment of the Gold Standard:
World War I had severe economic consequences, and many countries temporarily abandoned
the gold standard to finance the war effort. This abandonment resulted in volatile exchange
rates and disrupted the stability that the gold standard had previously provided.
 Post-War Economic Challenges:
After the war, countries faced the challenge of rebuilding their economies and dealing with
war debts. The economic reconstruction process was accompanied by high inflation and
financial instability in many nations.
 Treaty of Versailles and Reparations:
The Treaty of Versailles in 1919 imposed heavy reparations on Germany, contributing to
economic difficulties and hyperinflation in the country. These conditions had ripple effects on
other European economies and influenced exchange rates.
 Hyperinflation in Germany:
Germany experienced hyperinflation in the early 1920s, with the value of the German mark
plummeting. This had a profound impact on international trade and finance, as the German
mark's depreciation affected exchange rates with other currencies.
 Return to Gold Standard:
Some countries attempted to return to the gold standard in the 1920s, seeking to restore stability
to international trade and finance. However, the attempt was challenging, and several countries
faced difficulties maintaining the fixed exchange rates.
 Great Depression (1929-1939):
 The onset of the Great Depression in 1929 further destabilized the global economy. Many
countries abandoned the gold standard during the 1930s in response to economic challenges.
Exchange rates became more flexible, and competitive devaluations were employed to boost
exports.
 Currency Depreciations and Trade Barriers:
During the Great Depression, countries engaged in currency devaluations to gain a competitive
advantage in trade. Additionally, trade protectionism increased, with the imposition of tariffs
and other trade barriers.
Bretton Woods System (1944-1971):
The Bretton Woods system, established in 1944, was a landmark international monetary
framework created to promote stability and facilitate economic recovery after World War II.
Named after the Bretton Woods Conference held in July 1944 in New Hampshire, USA, the
system remained in place until 1971. Here are the key features and dynamics of the Bretton
Woods exchange rate system:
 Fixed Exchange Rates:
Under the Bretton Woods system, participating countries agreed to peg their currencies to the
U.S. dollar, and the U.S. dollar was, in turn, pegged to gold. This created a system of fixed
exchange rates, providing stability to the international monetary system.
 Gold-Backed U.S. Dollar:
The U.S. dollar became the primary reserve currency, and other currencies were pegged to it
at fixed rates. The U.S. committed to maintaining the convertibility of the dollar to gold at $35
per ounce, establishing a gold-backed anchor for the system.
 International Monetary Fund (IMF):
The Bretton Woods Agreement led to the creation of the International Monetary Fund (IMF).
The IMF was designed to provide short-term financial assistance to countries facing balance
of payments problems, helping them maintain stable exchange rates.
 World Bank:
The World Bank, another key institution established at Bretton Woods, aimed to provide long-
term financial assistance for the reconstruction and development of war-torn nations. It focused
on financing infrastructure projects and fostering economic development.
 Fixed Par Value System:
Countries agreed to maintain their exchange rates within a narrow margin (plus or minus 1%)
of their fixed par values. If a country's currency deviated beyond this margin, the IMF could
intervene to assist in restoring balance.
 Adjustable Peg System:
 While exchange rates were initially fixed, the system allowed for adjustments. Countries could
formally change their par values in response to changing economic conditions, subject to
approval by the IMF.
 Dollar Shortages and Marshall Plan:
In the early post-war years, there was a shortage of U.S. dollars in Europe. To address this, the
United States implemented the Marshall Plan, providing financial aid to European nations for
reconstruction. This helped stabilize the European economies and contributed to the success
of the Bretton Woods system.
 Challenges and Decline:
Over time, the Bretton Woods system faced challenges, including trade imbalances,
inflationary pressures, and the increasing cost of maintaining the gold convertibility of the U.S.
dollar. These challenges, along with the rising economic prominence of other countries, led to
strains on the system.
 Nixon Shock (1971):
In 1971, facing pressure due to persistent trade deficits and a growing supply of dollars,
President Richard Nixon announced the suspension of the dollar's convertibility to gold. This
move, known as the Nixon Shock, marked the end of the Bretton Woods system and the
transition to a system of floating exchange rates.
 Legacy and Influence:
Although the Bretton Woods system collapsed, its institutions, the IMF and the World Bank,
continued to play significant roles in the international financial system. The experience of
Bretton Woods also informed subsequent discussions on international monetary arrangements.
Flexible Exchange Rates (1970s Onward):
The move to flexible exchange rates, which gained momentum in the 1970s and continues to
characterize the contemporary international monetary system, marked a departure from the fixed
exchange rates of the Bretton Woods era. Here are key features and developments associated with
flexible exchange rates from the 1970s onward:
 Transition to Floating Exchange Rates:

With the breakdown of the fixed exchange rate system, major currencies were allowed to float
against each other. Exchange rates became determined by market forces of supply and demand
rather than being pegged to a fixed value.
 Managed Floats and Dirty Floats:
 While exchange rates are technically flexible, some countries engage in managed floats.
Central banks may intervene in currency markets to influence the value of their currencies.
This practice is often referred to as a "dirty float."
 Market Forces and Speculation:

Under flexible exchange rates, currency values are influenced by various market forces,
including economic indicators, interest rates, inflation rates, and geopolitical events.
Speculation in the foreign exchange market became more prevalent as traders sought to profit
from fluctuations in currency values.
 Exchange Rate Volatility:

The flexibility of exchange rates introduced a higher degree of volatility compared to the fixed-
rate regime. Currencies can experience significant and rapid movements based on economic
data releases, geopolitical events, and market sentiment.
 Trade Imbalances and Adjustment:

Flexible exchange rates allow for automatic adjustments in response to trade imbalances. If a
country runs a trade surplus or deficit, its currency's value will adjust to rebalance the trade
relationship.
 Independence in Monetary Policy:

Countries with flexible exchange rates have more autonomy in conducting their monetary
policies. Central banks can adjust interest rates and implement other monetary measures
without the constraints imposed by fixed exchange rates.
 Globalization and Capital Flows:

The era of flexible exchange rates coincided with increased globalization and international
capital flows. Financial markets became more interconnected, and capital could move more
freely across borders, influencing exchange rates.
Euro and European Monetary Union (1999 Onward):
The Euro and the European Monetary Union (EMU) represent a significant development in the
realm of international finance and monetary policy. Here are key aspects of the Euro and the
European Monetary Union from 1999 onward:
 Introduction of the Euro (1999):
The Euro, introduced on January 1, 1999, as an electronic currency for electronic
transactions, and in the form of banknotes and coins on January 1, 2002, is the official
currency of the Eurozone. The Eurozone comprises 19 of the 27 European Union (EU)
member states.
 Monetary Union Formation:
 The Euro's introduction marked the culmination of efforts to create a single currency and
a unified monetary policy for participating European countries. The European Monetary
Union (EMU) sought to deepen economic integration among member states.
 European Central Bank (ECB):
The Eurozone is served by the European Central Bank (ECB), which is responsible for
formulating and implementing monetary policy for the Eurozone. The ECB operates
independently and focuses on maintaining price stability as its primary objective.
 Eurozone Member Countries:
Initially, 11 EU countries adopted the Euro in 1999: Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece joined
in 2001, followed by Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia, and Slovenia.
 Monetary Policy Harmonization:
Eurozone countries share a common monetary policy, set by the ECB. The harmonization
of monetary policy across member states aims to foster stability and avoid individual
countries pursuing divergent policies that could create economic imbalances.
 Fiscal Policy Responsibility:
While the Eurozone has a common monetary policy, fiscal policy decisions remain the
responsibility of individual member states. This arrangement has sometimes led to
challenges, especially during periods of economic stress, as countries have limited fiscal
tools to address specific national economic issues.
 Impact on Exchange Rates:
The adoption of the Euro eliminated exchange rate risk between participating countries.
Eurozone countries no longer had separate national currencies with fluctuating exchange
rates against each other. This has simplified cross-border trade and investment within the
Eurozone.
 Challenges and Economic Divergence:
The Eurozone has faced challenges, including economic divergence among member states.
Varied economic conditions, fiscal policies, and competitiveness levels have led to
disparities in economic performance and contributed to debates about the sustainability of
the monetary union.
 Euro as an International Reserve Currency:
The Euro has become one of the world's major reserve currencies, alongside the U.S. dollar.
It is used in international trade and finance, and central banks around the world hold
significant reserves in Euro-denominated assets.
Technological Advances and High-Frequency Trading:
Technological advances, particularly the rise of high-frequency trading (HFT), have had a
profound impact on the foreign exchange (forex) market and, consequently, on exchange
rates. Here are some key effects:
 Increased Market Liquidity:
High-frequency trading relies on advanced algorithms and computer systems to execute a
large number of trades at incredibly high speeds. This increased trading activity can
enhance market liquidity, making it easier for buyers and sellers to transact and reducing
bid-ask spreads.
 Greater Efficiency and Price Discovery:
HFT systems can process vast amounts of market data in real-time, leading to more
efficient price discovery. Prices in the forex market are continually adjusted as these
systems analyze incoming information, allowing the market to incorporate new
information rapidly.
 Reduced Market Impact of Large Trades:
High-frequency traders often engage in strategies that involve making numerous small
trades. This can help in minimizing the market impact of large orders, as these orders are
broken down into smaller, less conspicuous transactions.
 Market Fragmentation:
The prevalence of high-frequency trading has led to the fragmentation of the forex market.
Trading venues and platforms have multiplied, and transactions occur across various
electronic communication networks (ECNs) and other platforms. This fragmentation can
affect price consistency across different platforms.
 Flash Crashes and Market Volatility:
While high-frequency trading aims to enhance market efficiency, it has been associated
with instances of flash crashes. These are rapid and severe price declines followed by quick
recoveries. The algorithms used by HFT systems can contribute to these events, especially
when market conditions become highly volatile.
 Concerns about Fairness and Market Integrity:
High-frequency trading has raised concerns about the fairness and integrity of financial
markets. Traders with advanced technologies and high-speed access may have an
advantage over traditional market participants. Regulators have had to address these
concerns to maintain a level playing field.
 Impact on Market Participants:
 The presence of high-frequency traders can affect the strategies and behaviors of other
market participants. Traditional asset managers may need to adapt their trading practices
to navigate a market where algorithms execute trades at speeds beyond human capability.
 Algorithmic Trading Strategies:
High-frequency trading involves a variety of algorithmic strategies, including market
making, statistical arbitrage, and trend following. These strategies contribute to the
complexity of the forex market and influence short-term price movements.
 Increased Emphasis on Technology and Connectivity:
As a result of high-frequency trading, there's a greater emphasis on technology and
connectivity in the financial industry. Financial institutions invest heavily in advanced
trading systems, data feeds, and low-latency infrastructure to remain competitive.
 Regulatory Responses:
The impact of high-frequency trading on financial markets has prompted regulatory
responses. Authorities have implemented measures to address concerns related to market
stability, fairness, and transparency. This includes the implementation of circuit breakers
and increased oversight of algorithmic trading activities.
Central Bank Policies and Currency Wars:
Central banks play a pivotal role in influencing exchange rates through monetary policies. The
concept of currency wars emerged as countries engaged in competitive devaluations to gain a trade
advantage, sparking concerns about the stability of the international monetary system.
 Interest Rates and Monetary Policy:
Central banks use interest rates as a tool to implement monetary policy attract foreign
capital, leading to currency appreciation, while lower interest rates may have the opposite
effect.
 Quantitative Easing (QE):
Central banks may engage in quantitative easing, a policy where they purchase financial
assets to increase the money supply and lower interest rates. QE can lead to currency
depreciation as investors seek higher-yielding assets in other currencies.
 Forward Guidance:
Central banks often provide forward guidance on their future policy intentions. Statements
regarding potential interest rate changes or other policy measures can impact market
expectations and influence currency values.
 Intervention in Foreign Exchange Markets:
 Central banks may directly intervene in foreign exchange markets to stabilize or influence.
Changes in interest rates can influence the attractiveness of a currency to investors. Higher
interest rates may
their currencies. Intervention can involve buying or selling currencies to counter excessive
volatility or address perceived misalignments.
 Currency Pegs and Bands:
Some countries maintain fixed exchange rate regimes, pegging their currencies to another
currency or a basket of currencies. Central banks in these countries actively intervene to
maintain the peg and stabilize exchange rates within certain bands.
 Currency Wars:
A currency war refers to a situation where countries compete to devalue their currencies to
gain a competitive advantage in international trade. This can involve deliberate
devaluations, interest rate cuts, or other measures to make exports more competitive.
Currency wars can lead to heightened exchange rate volatility.
 Competitive Devaluations:
In a currency war scenario, countries may seek to devalue their currencies to boost exports.
However, if multiple countries engage in competitive devaluations simultaneously, it can
result in a race to the bottom, creating uncertainties and destabilizing global markets.
 Trade Balances and Economic Competitiveness:
Central bank policies, including currency interventions and interest rate decisions, can
impact a country's trade balance. A weaker currency may make exports more competitive
but can also lead to higher import costs.
 Global Economic Imbalances:
Currency wars and competitive devaluations can contribute to global economic
imbalances. Persistent trade imbalances and unequal currency adjustments can lead to
tensions between countries and impact the stability of the international monetary system.
 Policy Coordination and Cooperation:
In some cases, central banks coordinate their policies to address common challenges. For
example, during the global financial crisis, central banks engaged in cooperative measures
to stabilize financial markets and support the global economy.
 Unintended Consequences:
Aggressive central bank policies and currency interventions can have unintended
consequences, including asset bubbles, excessive risk-taking in financial markets, and
challenges in managing inflation.
  Market Sentiment and Speculation:
Central bank actions and the perception of currency wars can influence market sentiment.
Traders and investors may engage in speculative activities based on expectations of central
bank policies, leading to short-term fluctuations in exchange rates.
Understanding the historical evolution of exchange rates requires considering these various
factors and events that have shaped the international monetary system over time. The ongoing
evolution of exchange rates reflects the interconnectedness of the global economy and the complex
interplay of economic forces on the currency markets.