You can be a millionaire in South Korean Won but only thousands in the US
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Before roughly the 1970s, most first world countries at least theoretically connected their currency to silver or gold or both. That is, they told people that if they went into a particular bank or system of banks, they could always exchange their paper currency for a particular quantity of gold or silver. There was also almost universally a system to deposit gold or silver in return for paper currency. This meant that currency was inherently tied to the real value, meaning the combination of the amount and the demand, of gold or silver. If for whatever reason, demand for paper currency was higher in relative terms than the demand for gold or silver, then people would go deposit their gold or silver and get paper currency in return. On the other hand, if demand for gold or silver was higher than that for paper currency, people would go to the bank and demand their gold or silver.
This system has a number of downsides. A couple of them are:
– If you really want everybody to be able to redeem their currency at any time, you have to have that amount of gold or silver in a vaullt somewhere, or many vaults. It takes real time and effort to build these vaults and to maintain security. This alone means that linking your currency to a precious metal inherently destroys value in the sense that the work people are doing to build and maintain the vaults is not work that anyone would want to do in the absence of this requirement
– The country’s ability to issue currency is limited not by the size of its real economy – meaning the actual amount of grain that’s being farmed and the amount of steel that’s being made and the amount of haircuts that are being given – but by its ability to obtain the precious metal. In most of modern history during and after the age of industrialization, the ability of people to make various goods has grown much more rapidly than the actual supply of gold or silver. That means that currency, which represents gold or silver, becomes more valuable relative to goods. That’s called deflation and it’s bad.
Imagine if you deposited $100,000 worth of gold in the bank this year, and somebody invented a steel plow that suddenly massively increased the ability of everybody to farm wheat and corn and so on. That means that your $100,000 will buy more wheat and corn and so on a year from now than it will today, because people will keep producing wheat and corn to sell it to make money. What that means is you want to keep your money, whether that’s in paper or precious metal form, and just sit on it as much as you can because you know that in the future you’ll be able to get better stuff for the same amount of money. But that money sitting there is not being spent on doing things like buying plows or paying people to actually do planting and harvesting. So the incentive you have to sit on your money ironically reduces the amount that the economy could grow, because people with money want to hoard it. This is an issue that can easily be controlled by a central bank that’s issuing a currency not dictated by a specific link to silver or gold, because the central bank and the government of the country as a whole can issue currency whenever they want. If the economy is growing faster than the currency supply and deflation is happening, then the government just makes more money in one way or another. On the other hand, if the currency supply is growing faster than the economy and inflation is happening, the government can remove money in one way or another.
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But enough about the relative costs and benefits of fiat currency versus hard money. To answer your question, basically, all economies began by using hard money, meaning precious metals or some other kind of durable resource. People would perform trade and that money would move around and if you discovered a bunch of silver mines in Peru, you could use that to buy a lot of goods in Europe or China, and the relative value of currencies was really just a function of the amount of gold or silver in them. Pirates loved to steal pieces of eight because you could spend a piece of eight anywhere. It had a specific known silver content, and no merchant would refuse it because they could see it and they knew how much silver it had. It didn’t matter that you were halfway across the world from spain, which is the country that actually manufactured the currency. The currency itself had value.
From there, people realized that it was both unsafe (because of the risk of theft) and really inconvenient to have to be carrying around a lot of heavy metal all the time. If they trusted somebody, or a company, that they knew had currency in, let’s say, Venice, and they wanted to go there, they would deposit currency with an office in their hometown of London and that office would give them a note saying that they were entitled to that same amount of currency, minus a small fee, in Venice. That way they don’t actually have to carry the money with them and as long as the people in Venice can recognize them in some way, even if somebody steals the note, that doesn’t mean the money’s gone.
Exchange rates were basically established at this time, when there was a large number of merchants called bankers providing these services. Based on the amount of gold or silver in a coin, they would be willing to change it for a different currency if you needed one. (One reason you might need a specific currency is to pay taxes to the monarch, who ensures there’s always a demand for his currency even if he starts reducing the silver content of it by demanding that all of his taxes be paid in his currency. Another reason is that it does actually cost time and effort to actively check every single coin for its precious metal content, so people would be more likely to trust local currency they had seen before.)
As for what happened after countries stopped using this system and stopped allowing people to draw gold from a bank on demand based on their paper currency, the answer is nothing much changed. People just kept on using the paper currency the same way they already had been and exchange rates are determined in the exact same way. If a government is issuing a lot of currency, then its value on the open market will go down relative to other currencies, and vice versa.
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