F/X Markets Today's Foreign Exchange Essay

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The stability is evident in the statistics as well. Between 1880 and 1914, the golden age of the gold standard, inflation averaged 0.1%. Between 1946-2003, even with Bretton Woods, inflation average 4.1% (Bardo, n.d.). Short-term price changes, however, could be highly unstable. This is a consequence of the fact that the gold standard ignores fundamental economic principles. Any system where the value of a good is established by artificial means is subject to such shocks. Another drawback to the gold standard is that it gives governments very little discretion over monetary policy. Another drawback is the cost of producing gold. The gold standard relies on having physical gold reserves. Thus, gold must be produced, and for that there is a cost (Ibid).

With the decline of Bretton Woods, the gold standard died. It was replaced by the modern foreign exchange system. At the core of this system are fiat currencies. Whereas currencies were once backed by the value of that nation's gold, dollar or pound reserves, now they were backed only by the implied power of the nation's economy. While this makes intuitive sense, it also means that no unit of currency has any underlying value. This is why today we have individual nations selecting a range of monetary policy regimes. The world's strongest economies have free-floating currencies. Others, such as China maintain a hybrid pegged float system, only slightly more flexible than that offered under Bretton Woods. Other countries maintain a hard peg, which in many cases leads to black market trading of their currencies.

The world's foreign exchange markets allow for trading, mainly in the free-floating currencies. Currencies are exchanged for a variety of reasons. International trade is one reason. In particular, banks need to access foreign exchange markets to meet the currency needs of their customers.

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Banks and other financial institutions also trade on their own accounts, and as a consequence are the world's most active participants in the foreign exchange markets.

Foreign exchange markets today are close to perfect competition, as reflected by the uniformity of the product offerings, the knowledge of the participants and the liquidity of the market. Today's foreign exchange markets are also characterized by a high use of derivatives, particularly futures contracts, which are traded in Chicago. Indeed, the Chicago Mercantile Exchange is the only central exchange for f/x trading, albeit only in derivatives. In the other major currency trading centers, there is no central trading system. Market participants must deal with one another directly, which is one of the major reasons why global banks are the most active forex participants.

Today's foreign exchange markets are characterized by liquidity and near-perfect competition. The markets today operate almost fully in context with the principles of market capitalism, occasional government intervention notwithstanding. The value of a currency reflects not its store of gold (itself a somewhat artificial source of wealth), but of the collective wealth of a nation's resources relative to other nations. This market is easy to access, through a bank or f/x dealer, and therefore easy to use for nearly everybody. The gold standard may have resulted in long-term stability, but it also was destined for collapse as it represented a distortion of true market conditions. Today's free currency exchange markets see greater long-term volatility in currency valuations, but are not subject to the same type of collapse because market changes are reflected on a near-constant basis.

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