The current currency rate mechanism has evolved over thousands of years. The world community has tried with various mechanisms to facilitate the trade of goods and services. Initially, the trading of goods and services was by barter system where in goods were exchanged for each other. For example, a farmer would exchange wheat grown on his farmland with cotton from another farmer. Such system had its difficulties primarily because of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty in valuation of services. For example, how does a dairy farmer exchange his cattle for few liters of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly, suppose wheat is grown in one part of a country and sugar is grown in another part of the country, the farmer has to travel long distances every time if/when he has to exchange wheat for sugar. Therefore, the need to have a common medium of exchange resulted in the innovation of money.
People tried various commodities as the medium of exchange ranging from food items to metals. Gradually metals became more prominent medium of exchange because of their ease of transportation, divisibility, certainty of quality and universal acceptance. People started using metal coins as medium of exchange. Amongst metals, gold and silver coins were most prominent and finally gold coins became the standard means of exchange. The process of evolution of medium of exchange further progressed into development of paper currency. People would deposit gold/ silver coins with bank and get a paper promising that value of that paper at any point of time would be equal to certain number of gold coins. This system of book entry of coins against paper was the start of paper currency.
With time, countries started trading across borders as they realized that everything cannot be produced in each country or cost of production of certain goods is cheaper in certain countries than others. The growth in international trade resulted in evolution of foreign exchange (FX) i.e., value of one currency of one country versus value of currency of other country. Each country has its own “brand” alongside its flag. When money is branded it is called “currency”. Whenever there is a cross-border trade, there is need to exchange one brand of money for another, and this exchange of two currencies is called “foreign exchange” or simply “forex” (FX).
The smooth functioning of international trade required a universally accepted foreign currency to settle the internal trade and a way to balance the trade imbalances amongst countries. This led to the question of determining relative value of two currencies? Different systems were tried in past to arrive at relative value of two currencies. The documented history suggests that sometime in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20. This mechanism of valuing currency was called as gold standard.
With further growth in international trade, changing political situations (world wars, civil wars, etc) and situations of deficit/ surplus on trade account forced countries to shift from gold standard to floating exchange rates. In the floating exchange regime, central bank’s intervention was a popular tool to manage the value of currency to maintain the trade competitiveness of the country. Central bank would either buy or sell the local currency depending on the desired direction and value of local currency.
During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they can convert their currency into USD at any time and USD value will be pegged to value of gold. Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar. With adoption of this system, USD became the dominant currency of the world.
Finally Bretton Woods system was suspended and countries adopted system of free floating or managed float method of valuing the currency. Developed countries gradually moved to a market determined exchange rate and developing countries adopted either a system of pegged currency or a system of managed rate. In pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. Although in long run it is difficult to maintain the peg and ultimately the central bank may change the value of peg or move to a managed float or free float. In managed float, countries have controls on flow of capital and central bank intervention is a common tool to contain sharp volatility and direction of currency movement.