The Most Important Features of the Bretton Woods Agreement - Essay Example

Student Name: Student Number: Unit: Unit Coordinator: Assignment: 02 Topic: Essay Topic No. 2 Describe the most important features of the Bretton Woods Agreement. Why did the Bretton Woods ‘system’ break down and what has replaced it? Due Date: Word Count: 2,085 International monetary exchange rate has always been a sign of concern for all countries in today’s world. Currency exchange rate plays an important role in the economic scenario since monetary policies are designed keeping in mind the international exchange rate. Factors such as inflation, deflation, recession, economic stability etc all revolve round the economic policy of a country which in turn is greatly dependent on the exchange rate. To understand the Bretton woods system of exchange rate, it is important to know why the agreement came into existence and reason for its breakdown to the present system of floating rate of exchange system. The same has been explained as under. International monetary system can be traced back to the traditional Gold Standard which came into existence in the year 1870 and was adopted and followed and followed by most countries globally. During the Traditional Gold Standard currency of a country was equally backed by the gold reserves it possessed. Thus, countries with higher gold mines or reserves were significantly more powerful than their counterparts with lesser gold mines in their country (Dooley, Folkerts-Landau and Garber, 2006, p. 187). Gold Standard implied that any person holding the paper currency of the country could exchange their paper currency with equal and par value of gold from their governmental bodies set up for this purpose and vice-versa. Thus, a countries paper currency was equally backed up in real terms with the gold reserves of the county. Gold Standard thus further provided long term stability in the price of goods and helped in controlling inflation globally (Bordo and Eichengreen, 2008, p. 13). It was so designed that it would automatically adhere to shocks in the economy and maintained equilibrium in the country’s economy. Gold Standard done quite well during its initial years of implementation but however started showing signs of dismay and loopholes with progress of time since with more development of the economy countries started facing severe problems due to shortage of paper currency and limitation of gold reserves in the country. In no situations could a country inflict more currency in its economy without backing the same with its gold reserves. During the period of Great Depression powerful countries like The Great Britain showed signs of panic and complete nervous breakdown due to shortage of currency which was followed by other countries of the world. There was huge requirement of funds during the World War-1 for war equipment’s and further for social programs and welfare which was not available in the economy and the Gold Standard did not permitted to inflict new currency notes without equal backup of gold reserves (Dooley, Folkerts-Landau and Garber, 2009, p. 456). The situation further worsened during The Great Depression as Federal Bank kept inflating the interest rate to make dollar more powerful and save its gold reserves which was indeed followed a major global recession and finally countries decided to abolished Gold standard. Once the Traditional Gold Standard was abolished by powerful country like Great Britain in the year 1914, the period between1918 to 1939 so regarded as the Interwar Period saw many ups and down and countries kept reverting back to the Gold Standard at different interval of time. Countries like the United States returned back to Gold Standard, followed by powerful country like The Great Britain in the year 1925. However, Great Britain again discontinued the Gold Standard adopted by them in the year 1931 due to post effect of World War-2 and the economic instability that it faced during the Great Depression which largely affected its gold reserves and its failure to introduce new monetary policies and currency to stabilise its economy. Even United States finally abolished the Gold Standard in 1933 but however again reverted back to the Gold Standard in the year 1934 with a standard rate of $35 per ounce of gold. It was finally the post war consequences of World War-2 and the international liquidity crunch which finally lead to complete abolishment of Gold Standard and development of The Bretton Woods system (Eichengreen, 2008, p. 43). In order to develop an international monetary system of freely convertible currency and build on the post war economic situation, 730 delegates from all Allied Nations came together in Bretton Woods, New Hampshire, United States and made a consensus on a new monetary system which derived its name from the place itself and came to be known as The Bretton Woods Agreement. The Bretton Woods Agreement in a nutshell outlined new policies, rules and regulations to run an international monetary system smoothly. A fixed exchange rate was linked to U.S. dollars ($) which had emerged as the most powerful currency of the world post World War and other countries pegged their currency with the United States dollar. Thus, U.S. dollars became the base of all exchange rates (Bordo, 1993, p. 27). Bretton Woods Agreement was adopted by almost all countries of the world and The Traditional Gold Standard was abolished by almost all countries of the world post World War-2. The Bretton Woods Agreement is discussed as under: New international bodies came into existence for the first time. The International Monetary Fund and World Bank was a result of the Bretton Woods Agreement to regulate the international trade and exchange rate system (Bordo, 1993, p. 29). Traditional Gold Standard was abolished and U.S. dollars emerged as the most powerful currency in the world which was pegged to gold at a fixed rate of $35 per ounce of gold and other countries pegged their currency with U.S. dollars (Bordo, 1993, p. 29). Members of International Monetary Fund (IMF) were solely responsible to maintain their exchange rate with a slight variance of allowable 1% of variance on either side to the adopted fixed par value of dollar by either selling or purchasing its foreign reserves as required. Bretton Woods System can be regarded as a dollar based exchange rate system tied with the traditional Gold Standard. The new system aimed to remove deficit in Balance of Payment as each member of the IMF could change its par value only on the approval of the members of the fund. The new system also aimed at maintaining International Liquidity as any country adopting to the new Bretton Woods System so as to become its member has to subscribe as per its quota which consists of 25% subscribed in terms of $ or gold and the rest in the respective currency of the country (Dooley, Folkerts-Landau and Garber, 2004c, p. 127). The Bretton Woods system did not lay down or kept any provision for reserves in cases of contingency or emergency situations. The system allowed its member countries free trade as there was no restriction on current account transactions. International Monetary Fund (IMF) aimed at providing a stable exchange rate and further provided its member nations to borrow in situations of temporary balance of payment situations (Eichengreen, 2007, p. 13). Bretton Woods System linked itself with Gold Standard since U.S. dollars was pegged with gold. During the time of deficit or surplus in the Balance of Payment situations in the Traditional Gold Standard, deflationary policy was the only choice available to the countries. However, Bretton Woods System allowed both deflationary policies and devaluation in the country’s currency as well to maintain equilibrium in the economy (Dooley, Folkerts-Landau and Garber, 2004b, p. 98). Thus, Bretton Woods Agreement aimed at maintaining an international exchange rate within a fixed value and tried to maintain equilibrium in the exchange rates by removing the deficits in international Balance of Payments. Bretton Woods System worked smoothly during its initial years but it soon started showing signs of loopholes as did the Traditional Gold Standard (Enders, 2004, p. 73). The very assumption of fixing the U.S. dollars to a fixed exchange rate of gold of $35 per ounce of gold lacked to consider the real and changing value of gold in the longer run. Balance of Payment deficit kept on rising in the United States and to devalue dollar was an impossible task as all currencies were liked to U.S. dollars and devaluation would create complete disorder in the economic scenario. Further dollar lost substantial portion of its purchasing power in during World WAR-2 and as European economy tried to backup, it further led to huge drainage of gold reserves of the United States (Dooley, Folkerts-Landau and Garber, 2004a, p. 49). Bretton Woods System failed to maintain international liquidity and for the same many reforms was introduced such as increase in the number of members of the fund and introduction of Special Drawing Rights (SDR) which were distributed among the member nations on basis of their proportion and could be used in situations of difficulty in the Balance of Payment or in case a member nation wished to increase its international monetary reserves. In spite of timely reforms in the system, Balance of Payments were on the rise and United States was finally forced to devalue dollar by about 9%, from $35 per ounce of gold to $38 per ounce of gold and the variance of member nations was changed to 2.25% to the devalued dollar amount (Dooley, Folkerts-Landau and Garber, 2004, p. 312). This resulted in huge drainage of funds from the United States and it interest rate kept on rising with an increase in the deficit of Balance of Payment and it finally suspended the convertibility of dollars into gold and the Bretton Woods system came to an end in 1973 and was abandoned by most of the countries in the world. Thus in a nutshell, Bretton Woods System collapsed as a result of dominance of U.S. dollar, deficit Balance of Payment and finally undervaluing of dollar to maintain International Liquidity and equilibrium in the economy. Bretton Woods System collapsed in the year 1973, and all members of IMF decided to introduce a floating or flexible exchange rate of system and gold was no longer regarded as an international reserve asset. Different countries were allowed to lay objective of their macroeconomic as per their requirements and was also allowed to choose a different inflation rate based on international exchange rate and purchasing power of the currency. Floating Exchange rate was a newer concept since a shift was made from the fixed exchange rate to a floating exchange rate system. Flexible exchange rate allowed an economy to absorb shocks and possibility of deficit Balance of Payment was considerably lowered. Floating rate promotes economic development as monetary policy could be easily laid down as per the requirement of the economy. It further promotes international trade freely and helps in maintaining International Liquidity (Cohen, 2002, p. 125). It was much successful in preventing speculations in the international market in its early days which was not possible in the fixed exchange rate system. On the other hand, flexible exchange rate has its own limitations and disadvantages like it has a low elasticity due to low elasticity in international trade of import and exports as the exchange rate keeps fluctuating on a regular basis (Eichengreen, 2004, p. 37). Economic structure of a country is thus affected by this low elasticity to a considerable extent. Flexible exchange rate has a problem of unnecessary drainage of capital movements due to speculative activities in the international trade which creates liquidity problems globally (Dooley, Folkerts-Landau and Garber, 2003, p. 9). Further since each country has its own inflation and deflation rates as per the economic situation. A higher inflation rate lowers the purchasing power and adversely depreciates the currency both locally and globally. A complete study of the different phases of exchange rate has been studied in the given assignment. Economy has responded differently in different situation as per the requirement. There has been a complete shift in the international exchange rate from the fixed rate of exchange system prevailing during the Traditional Gold Standard to a Floating rate of exchange system as present in today’s economic environment (Dooley, Folkerts-Landau and Garber, 2005, p. 238). Bretton Woods System had its own advantages and disadvantage over the floating exchange rate system. However, a shift was necessary to the Floating Rate of exchange system. It is to be noted by 2001, almost half the member countries of International Monetary Fund (IMF) had adopted the Floating Rate of Exchange System and in today’s global economic scenario almost all countries of the world has adapted this system to maintain a smooth International trade and equilibrium in its Balance of Payment References Bordo, M. (1993). ‘The Bretton Woods International Monetary System: A Historical Overview’, in M. Bordo and B. Eichengreen (eds), A Retrospective on the Bretton Woods System, Chicago, University of Chicago Press, pp. 3-108. Bordo, M. D. and Eichengreen, B. (2008). ‘Bretton Woods and the Great Inflation’, NBER Working Paper 14532. Cohen, B. J. (2002). ‘Bretton Woods System’ in R. J. B. Jones (ed) Routledge Encyclopaedia of International Political Economy, London, Routledge. Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2003). ‘An Essay on the Revived Bretton Woods System’, NBER Working Paper 9971. Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2004). ‘The Revived Bretton Woods System’, International Journal of Finance and Economics, Vol. 9, pp. 307-313 Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2004a). ‘The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates Center Countries’, NBER Working Paper 10332. Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2004b). ‘Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery’, NBER Working Paper 10626. Dooley, M. P., Folkerts-Landau, D. and Garber. P. M. (2004c). ‘The US Current Account Deficit and Economic Development Collateral for a Total Return Swap’, NBER Working Paper 10727. Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2005). ‘Saving Gluts and Interest Rates: The Missing Link to Europe’, NBER Working Paper 11520 Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2006). ‘Interest Rates, Exchange Rates and International Adjustment’, Paper presented at the 51st Economic Conference of the Federal Reserve Bank of Boston. Dooley, M. P., Folkerts-Landau, D. and Garber, P. M. (2009). ‘Bretton Woods II Still Defines the International Monetary System’, NBER Working Paper 14731. Eichengreen, B. (2004). ‘Global Imbalances and the Lessons of Bretton Woods’, NBER Working Paper 10497. Eichengreen, B. (2007). Global Imbalances and the Lessons of Bretton Woods. National Bureau of Economic Research, Cambridge, MA. Eichengreen, B. (2008). Globalising Capital: A History of the International Monetary System, 2nd edition, Princeton, N.J., Princeton University Press. Enders, W. (2004). Applied Econometric Time Series, 2nd edition, New York, Wiley. Read More