B. Fixed and floating rates

For 25 years after World War II, the levels of most major currencies were determined by governments. They were fixed or pegged against the US dollar (e.g. from 1946-67, one pound was worth $2.80), and the dollar was pegged against gold. One dollar was worth one thirty-fifth of an ounce of gold, and the US Federal Reserve guaranteed that they could exchange an ounce of gold for $35. This system was known as gold convertibility. These fixed exchange rates dould only be adjusted if the International Monetary Fund agreed. Pegging against the dollar ended in 1971, because following inflation in the USA, the Federal Reserve did not have enough gold to guarantee the American currency.

Since the early 1970s, there has been a system of floating exchange rates in most western countries. This means that exchange rates are determined by people buying and selling currencies in the foreign exchange markets. A freely floating exchange rate means one which is determined by market forces: the level of supply and demand. If there are more buyers of a currency than sellers, its price will rise; if there are more sellers, it will fall.

Since the introduction of a common currency in 2002, fluctuating exchange rates among many European countries are no longer a problem. But the euro continues to fluctuate against the US dollar; the Japanese yen and other currencies.