The following is an overview into the historical evolution of the foreign exchange market and the roots of the international currency trading, from the days of the gold exchange, through the Bretton-Woods Agreement, to its current manifestation.

The Gold exchange period and the Bretton-Woods Agreement

The Bretton-Woods Agreement, established in 1944, fixed national currencies against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had inteded to use the funds to short the British currency. The bank's refusal to grant the loan was due to the Bretton-Woods Agreement.

Bretton-Woods was aimed at establishing international monetary stability by preventing money from taking flight across countries, thus curbing speculation in foreign currencies. Between 1876 and World War I, the gold exchange standard had ruled over the international economic system. Under the gold standard, currencies experienced an era of stability because they were supporte by the price of gold.

However, the gold standard had a weakness in that it tended to create boom-bust economies. As an economy strenghtened, it would import a great deal, running down the gold reserves required to support its currency. As a result, the money supply would diminish, interst rates would escalate and economic activity would slow to the point of recession. Ultimately, prices of commodities would hit rock bottom, thus appearing attractive to other nations, who would then sprint into a buying frenzy. In turn, this would inject the economy with gold until it increased its money supply, thus driving down interest rates and restoring wealth. Such boom-bust patterns were common throughout the era of the gold standard, until World War I temporarily discontinued trade flows and the free movement of gold.