Understanding the origins of fluctuating exchange rates may help you succeed in the Forex market. Approaching the conclusion of World War II, the Allies met in Bretton Woods, New Hampshire to design the financial future of its members. The major outcome was to have the U.S dollar pegged to gold, and to have the other major currencies of the world pegged against the dollar. For example, if the British pound started to deviate from the dollar, Britain would buy or sell its own currency to force the pound back to a rate equivalent to the dollar.
By pegging their rates to the U.S. dollar, the member states' economies were intertwined. The integration of these states' economies was more severe than originally anticipated. As a result, monetary policy makers in all the related countries were forced to manipulate interest rates more often, and more quickly. Interest rates are used by monetary policy makers to influence the growth of their economies. The balance between maintaining an exchange rate and guiding an economy was never achieved, and a great deal of unnecessary economic volatility ensued.In the early seventies, Bretton Woods was abandoned in favor of floating exchange rates. A floating rate system allows market forces to determine exchange rates. Specifically, exchange rates of any country are the equilibrium between supply and demand for its currency. As a result, monetary policy makers could focus on their respective economies rather than exchange rate manipulation.In reality, many countries still peg their currencies to the U.S. dollar. Most notably, China and Japan use the U.S. dollar for their benchmarks. As an investor, you should be especially careful in trading the yen because the Bank of Japan periodically steps into the market to influence its exchange rate. Japan makes no warning, so be warned that if you are on the wrong side of this transaction, you will pay dearly.
