A foreign exchange market is one in which those who want to buy a certain currency in exchange for another currency and those who want to move in the opposite direction are able to do business with each other. The motives of those desiring to make such exchanges are various. Some are concerned with the import or export of goods between one country and another, some with the purchase and sale of services. Some wish to move capital from one area to the other, and some wish to make gifts (the latter including government aid and gifts by charitable foundations).

In any organized market there must be intermediaries who are prepared to “quote a price,” in this case a rate of exchange between two currencies. These intermediaries must move the price quoted in such a way to permit them to make the supply of each currency equal to the demand for it and thus to balance their books. In an important foreign exchange market the price quoted is constantly on the move.

An exchange rate is the price of one currency in terms of another. For example, in the market for the British pound sterling (£) in exchange for U.S. dollars ($), the exchange rate might be £1 = $2. This price may also be quoted the other way around; that is, $1 = £0.50.

In a foreign exchange market, there may be a standard, government-determined price, or par value. This par value may be quoted in terms of another currency; for example, the par value of the pound was £1 = $2.80 between 1949 and 1967. In 1973 many governments abandoned their par values and let their exchange rates be determined by the forces of demand and supply. An exchange rate determined in this way, without being tied to an official par, is called a flexible or floating exchange rate; in contrast, an exchange rate is said to be pegged if the government ties it to par value.

Historically, countries often tied their currencies to gold, setting their official parities in terms of that metal. Under this historical gold standard, the gold equivalence of currencies determined exchange rates. For example, the British pound was worth 4.86 times as much gold as the U.S. dollar during the period prior to World War I. The exchange rate remained at or quite close to the mint parity of £1 = $4.86. Nobody would pay much more than $4.86 for a British pound or take much less.

Historically, there were also periods of bimetallism, when the gold standard was combined with a silver standard, and currencies were fixed in terms of both gold and silver. The bimetallic standard was given up by most of its adherents (the United States, France, Italy, Switzerland, the Netherlands, and Belgium) in the 1870s.

If the demand by those holding a particular currency, say sterling, for another currency, say the dollar, exceeds the demand of dollar holders for sterling, the dollar will tend to rise in the foreign exchange market. Under the gold standard system there was a limit to the amount by which it could rise or fall. If a sterling holder wanted to make a payment in dollars, the most convenient way for him to procure the dollars would be in the foreign exchange market. But under the gold standard he had another option; i.e., he had a legal right to obtain gold from the authorities in exchange for paper currency at the established par value of that currency and remit the gold to the other country, where he would have a legal right to obtain its currency in exchange for bars of gold at the official valuation. Thus, it would not be advantageous for a sterling holder to obtain dollars in the foreign exchange market if the quotation for a dollar there exceeded parity by more than the cost of remitting gold. The exchange rate at which it became cheaper to remit gold rather than use the foreign exchange market was known as the “gold-export point.” There was also a “gold-import point” determined on similar lines.

Most of those seeking dollars, however, did not undertake to remit gold even if the dollar quotation was at the gold-export point. The remission of gold was handled by arbitrageurs. These are people who buy and sell currencies simultaneously on different exchanges in order to profit by small differences in the quoted rates. Their action would reduce the supply of sterling, since they would be selling sterling for gold to the British authorities, and increase the supply of dollars, since they would acquire dollars in exchange for gold from the U.S. authorities. The arbitrageurs would carry out these operations to the extent needed to prevent the scarcity of the dollar from raising its sterling price above the gold-export point for the United Kingdom, and conversely. At the same time, the gold reserve of the British authorities would be diminished, and the gold reserve of the U.S. authorities increased.

The international gold standard provided an automatic adjustment mechanism, that is, a mechanism that prevented any country from running large and persistent deficits or surpluses. It worked in the following manner. A country running a deficit would see its currency depreciate to the gold-export point. Arbitrage would then result in a gold flow from the deficit to the surplus country. In other words, the deficit would be settled in gold.

The gold flow had an effect on the money system. When gold flowed into the banking system of the surplus country, its money stock rose as a consequence. On the other side, when a deficit country lost gold, its money stock fell. The falling money stock caused deflation in the deficit country; the rising money stock caused inflation in the surplus country. Thus, the goods of the deficit country became more competitive on world markets. Its exports rose, and its imports declined, correcting the balance-of-payments deficit.