The interwar years and World War II, 1914-1944

During World War I and the early 1920s, currencies were allowed to fluctuate over fairly wide ranges in terms of gold and each other.Theoretically, supply and demand for a country’s exports and imports caused moderate changes in an exchange rate about a central equilibrium value.This was the same function that gold had performed under the previous gold standard.Unfortunately, such flexible exchange rates did not work in an equilibrating manner.On the contrary: international speculators sold the weak currencies short, causing them to fall further in value than warranted by real economic factors.Selling short is a speculation technique in which an individual speculator sells an asset such as a currency to another party for delivery at a future date.The speculator, however, does not yet own the asset, and expects the price of the asset to fall by the date when the asset must be purchased in the open market by the speculator for delivery.

The reverse happened with strong currencies.Fluctuations in currency values could not be offset by the relatively illiquid forward exchange market except at exorbitant cost.The net result was that the volume of world trade did not grow in the 1920s in proportion to world gross domestic product but instead declined to a very low level with the advent of the Great Depression in the 1930s.

The United States adopted a modified gold standard in 1934 when the US dollar was devalued to $35 per ounce of gold from the $20.67 per ounce price in effect prior to World War I.Contrary to previous practice, the US Treasury traded gold only with foreign central banks, not private citizens.From 1934 to the end of World War II, exchange rates were theoretically determined by each currency’s value in terms of gold.During World War II and its chaotic aftermath, however, many of the main trading currencies lost their convertibility into other currencies.The dollar was the only major trading currency that continued to be convertible.