$~~~~$In finance, an exchange rate is the rate at which one country’s currency is exchanged for the currency of another. The rate is set according to the respective values of the currencies to be exchanged. Before World War I, most currencies were evaluated by the Gold Standard. That is, paper currency issued by a government represented a real amount of gold held by that government. For example, in the 1930s, the British government owned about 8 times as much gold as the U.S. government. Therefore, 1 ounce of gold was worth 4.24 GBP (United Kingdom pound sterling) or 35 USD (U.S. dollars). The difference in the price of gold became the exchange rate for the two currencies: 1GBP was worth 8.25 USD.
$~~~~$The Gold Standard started to break down during the Second World War, when European powers printed more money than they had in gold reserves in order to fund military projects. After World War II, the Bretton Woods System was established. The U.S. dollar was chosen as the international reserve currency for trading. Every country knew how much gold a USD was worth, and thus they based the value of their currencies on the USD. All countries were expected to maintain a fixed exchange rate, but were permitted to change it in extraordinary times, such as a recession or inflation.
$~~~~$Unfortunately, this system could not keep pace with the fast-changing global economy. As the U.S. increased its military spending, foreign aid, and international investment in the 1960s, it no longer held gold reserves necessary to cover the volume of USD circulation around the world. Other major currencies thus became more valuable and stable compared to the USD, and the Bretton Woods System was finally abolished in 1971.
$~~~~$In 1976, the Jamaica Agreement formalized the floating exchange rate system that continues to this day. The value of a country’s currency may vary according to the supply and demand of the foreign exchange market. Countries around the world can also allow their central banks to determine their own exchange rate.