In the past, countries used gold to back their money, meaning one could exchange currency for a fixed amount of gold. For example, the U.S. followed this system, called the Gold Standard, until 1971. Global trade also relied on gold through the Bretton Woods Agreement, where the U.S. dollar was tied to gold at $35 per ounce, and other currencies were linked to the dollar.
In 1971, President Nixon ended this system, a move called the Nixon Shock. This change led to the use of fiat money, which isn’t backed by gold or any other physical asset. Instead, the value of money is now determined by market forces like supply and demand.
To understand this system lets see an example
Under a gold-backed currency system, trade between two countries involved the transfer of gold to settle imbalances. Suppose Country A and Country B each have 10 grams of gold in their central banks, and their currencies are pegged to gold: 1A = 1 gram of gold for Country A and 1B = 2 grams of gold for Country B. If Country B imports wheat from Country A worth 10A, it must first exchange its currency. With the exchange rate fixed at 1A = 0.5B, the importer in Country B needs to provide 20B to acquire 10A. Once the payment is made, the trade imbalance is settled through a transfer of gold. Since 10A is equivalent to 10 grams of gold, Country B’s central bank sends 10 grams of gold to Country A’s central bank. After this transaction, Country A’s gold reserves increase to 20 grams, while Country B’s reserves drop to 0 grams. This demonstrates how gold reserves shifted between countries to balance trade under the gold standard, with currencies acting as proxies for gold
Now to understands how today’s currency work let's delve more into the topic
Modern currencies are fiat money, meaning their value is based on trust in the issuing authority (usually a government or central bank) rather than being backed by physical assets like gold or silver. Fiat money has no intrinsic value; it's worth comes from the public’s trust in the government and the economy. It is declared as legal tender, meaning it must be accepted as payment within the issuing country. Central banks (e.g., Central Bank Of India , Federal Reserve in the U.S., European Central Bank) issue and control currency. They regulate the money supply to prevent inflation or deflation. Most modern currencies have values determined by supply and demand in global forex markets .For Example ,If investors want more U.S. dollars, its value increases relative to other currencies.
Global trade plays a big role in how currencies gain or lose value. Here's how it works:
A. Trade Balance
Trade Surplus exports > imports
When a country sells more goods than it buys, it increases demand for its currency because other countries need it to pay for those goods.
Example: China exports a lot, so the demand for its currency, the yuan, goes up.Trade Deficit imports > exports
When a country buys more goods than it sells, it needs more foreign currencies, which weakens its own currency.
Example: The U.S. often imports more than it exports, which can lower the value of the dollar.
B. Exchange Rates and Trade
Strong Currency
When a currency is strong, it’s cheaper to buy goods from other countries (imports), but it makes a country’s goods more expensive abroad, which can hurt local industries.Weak Currency:
When a currency is weak, it’s easier to sell goods internationally (exports become cheaper), but it makes imported goods more expensive, which can lead to higher prices (inflation).
C. Capital Flows
Foreign investment in a country boosts demand for its currency, making it stronger.
Example: If people from around the world invest in U.S. bonds or stocks, they need dollars, which increases the dollar’s value.
The foreign exchange (forex or FX) market is the global marketplace for buying and selling currencies. It's the largest and most liquid financial market in the world, with daily trading volumes exceeding $6 trillion (as of 2023). The forex market operates 24 hours a day, five days a week, and consists of banks, financial institutions, corporations, governments, and individual traders who buy and sell currencies.
To understand how foreign exchange works lets see an example
Let’s consider an forex trading between two countries, Country A and Country B. Suppose a company in Country A wants to import machinery from a supplier in Country B, and the total cost of the machinery is 1,000 units of Beta. The current exchange rate is 1 Alpha = 90 Beta, so the company in Country A needs to exchange 90,000 Alpha for 1,000 Beta to make the payment. The company goes to a forex broker or bank in Country A to exchange the Alpha for Beta and then transfers the 1,000 Beta to the supplier's account in Country B. However, the forex market is constantly fluctuating, and changes in the exchange rate can impact the transaction. If Alpha weakens, for instance, and the exchange rate shifts to 1 Alpha = 95 Beta, the company in Country A would need to exchange 95,000 Alpha for the same 1,000 Beta, meaning the cost of the machinery in Alpha terms would increase. Conversely, if Alpha appreciates and the exchange rate improves to 1 Alpha = 85 Beta, the company would need only 85,000 Alpha to buy 1,000 Beta, reducing the cost in Alpha. Factors such as interest rate changes, inflation, geopolitical events, and market speculation can all influence the exchange rate between Alpha and Beta, affecting how much the company in Country A will need to pay for the imported goods. For example, if Country B's central bank raises interest rates, Beta could strengthen, increasing the cost for the company in Country A to buy Beta. Similarly, political instability or economic conditions in Country A could cause Alpha to depreciate, making imports from Country B more expensive.
Now lets see the types of rates in currency exchanges .
Floating Exchange Rate Vs Fixed Exchange Rate.
A floating exchange rate is a system where the value of a country's currency is decided by the forces of supply and demand in the foreign exchange market. This means the currency's value changes frequently based on factors like trade, economic performance, and global events. For example, if a country exports more goods, its currency might become stronger. The biggest advantage of this system is flexibility; the currency adjusts automatically to economic changes. However, it can also be unpredictable, which makes international trade and investments riskier.
On the other hand, a fixed exchange rate is a system where a country’s currency value is tied to another currency, a group of currencies, or a commodity like gold. For instance, if a country pegs its currency to the US dollar, its value will stay stable in comparison to the dollar. This stability makes it easier for businesses to trade internationally without worrying about sudden currency value changes. However, maintaining this stability can be costly because the government or central bank must use its reserves to keep the currency value fixed, even if it doesn't match the country's economic conditions.
In simple terms, floating exchange rates are like prices in an open market that go up and down based on demand and supply, while fixed exchange rates are like prices set by the government that stay stable but require constant monitoring and adjustment. Each system has its advantages and challenges, and countries choose one based on their economic needs and goals.
Conclusion
Currencies operate within a complex system where value is influenced by a range of factors, including economic conditions, inflation, interest rates, and political stability. Geopolitics plays a major role, as countries with strong political influence and economic power, like the U.S., have historically seen their currencies dominate global trade, finance, and reserves. The rise of BRICS (Brazil, Russia, India, China, and South Africa) has challenged this dominance, as these nations work to reduce their reliance on the U.S. dollar by promoting the use of local currencies in trade . BRICS aims to create a more multipolar financial system, reducing the geopolitical leverage of the U.S. but facing challenges in overcoming the entrenched dominance of the dollar. As global power dynamics shift, the future of currency markets and their geopolitical impact remains uncertain, with a potential for increased competition and diversification in the global financial system.
EXTRA INFO.
The U.S. dollar is the world’s primary reserve currency, holding approximately 58% of global foreign exchange reserves as of 2023 (IMF data).
Breakdown of Reserve Currencies (G20 Context):
U.S. Dollar (USD): 58%
Euro (EUR): 20%
Widely held by the Eurozone nations, including Germany, France, and Italy (G20 members).
Japanese Yen (JPY): 5.5%
Held by major economies like Japan and others for trade and investment purposes.
British Pound (GBP): 4.9%
The U.K., as a G20 member, contributes to its significance as a reserve currency.
Chinese Yuan (CNY): 3.2%
The People's Bank of China actively promotes yuan usage in global trade and reserves.
Other Currencies: 8.4%
Includes currencies like the Australian Dollar (AUD), Canadian Dollar (CAD), and others from G20 nations.
G20 Contributions to Global Forex Reserves:
G20 countries collectively account for over 85% of global GDP and hold the majority of the world's foreign exchange reserves.
Among G20 members:
China: Holds the largest forex reserves globally, valued at over $3.2 trillion.
India: Maintains significant reserves, totaling approximately $600 billion.
Russia: Despite sanctions, its reserves exceeded $550 billion pre-2022, with a strategic pivot towards gold and yuan.
The Role of Gold in Forex Reserves
Many G20 countries still hold significant gold reserves as a hedge against currency volatility:
United States: Largest gold reserve at 8,133 tonnes.
Germany: Second-largest with 3,355 tonnes.
China: Increasing its gold reserves to reduce reliance on USD, with holdings surpassing 2,100 tonnes.
India: Holds approximately 800 tonnes, diversifying its forex reserves.
3. Reserve Currency Usage in Trade
Petrodollars: Oil is predominantly priced and traded in USD. Major G20 oil exporters like Saudi Arabia, Russia, and Canada reinforce the dollar’s importance.
Bilateral Agreements: G20 nations like India and Russia have begun using local currencies or alternative arrangements (e.g., Vostro Accounts) to reduce reliance on USD in trade.
4. The Role of BRICS in Reserve Currency Debate
The BRICS Contingent Reserve Arrangement (CRA) aims to provide financial support to member nations, potentially creating a shift in global currency reserves.
As of 2023, BRICS countries hold nearly 25% of global GDP, challenging the dollar's monopoly by promoting local currencies in trade.
5. Digital Currencies and Reserve Status
Central Bank Digital Currencies (CBDCs):
G20 countries like India, China and Brazil are also exploring CBDCs to modernize payment systems and reduce reliance on the USD.
6. Reserve Currency and Geopolitical Power
Economic Sanctions: The U.S. dollar’s dominance enables the U.S. to impose global sanctions, e.g., freezing Russian assets post-2022. This has accelerated efforts among BRICS countries to explore dollar alternatives.
IMF Special Drawing Rights (SDR): Comprising USD (42%), Euro (31%), CNY (11%), JPY (8%), and GBP (8%), SDR reflects the evolving reserve currency mix.