Bretton Woods Agreement - Assignment Example

Student Name: Type your name here Student Number: Type your student number here Unit: Type the unit here Unit Coordinator: Type the name here 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: 30 April 2012 Word Count: 2,032 Monetary system has grown through several changes and phases. To understand Bretton Woods System, it would be helpful to understand the history behind the same and the causes for its decline to a floating rate system in the present scenario. An international exchange rate has been always eyed upon right from the Classical Gold Standard. The Gold Standard came into existence in the year 1870 where most countries of the world adopted the Gold Standard. Currency of every country was backed by the gold reserves in the country which gave the paper currency value in real terms. Anyone holding a paper currency of the country could exchange the same for a par value of gold from the governmental gold reserves and vice-versa (Swamy and Tavlas, 2005). Thus, during the Gold Standard a currency was equally backed by the gold reserves that a country possessed. Thus, the Gold Standard provided long run price stability in the economy and was so designed that it would automatically adhere to shocks in the economy and maintainedan equilibrium. However, the Gold Standard during World War-1 and The Great Depression started showing signs of dismay and loopholes mainly on account of the following reasons (Meltzer, 1991). Since, during the Gold Standard a currency was equally backed by the gold reserves of the country, each country has limited gold reserves which could not keep in pace with the international and national trade growth rate. Powerful countries like The Great Britain panicked during The Great Depression which was followed by other countries of the world. There was huge requirement of fund during the World War-1 and for social programs and welfare which was not readily available as new currency could only be inflicted in the economy with an equal back of gold reserves for the same, which was not possible during the World War-1 Scenario. Further during The Great Depression, Federal Reserve kept inflating its interest rates to make dollar a more powerful currency and save its gold reserves which further worsened the economic scenario and the world was hit by greater Recession (Obstfeld, 1993). Finally in the 1914, Gold Standard was abolished by most of the countries of the world for a time being. Soon after the end of Classical Gold Standard in the year 1914, the period between 1918 to 1939 was regarded as the Interwar period in the history of monetary policy. Country like United States returned back to Gold Standard as there was little inflation during the war, even the most powerful county like The Great Britain returned back to the Gold Standard in the year 1925. However, during the Second World War, and at times of Great Depression, gold reserve of Great Britain was largely affected and it discontinued Gold Standard in the year 1931 (Roubini, 2004). United States abolished Gold Standard in the year 1933 but however returned back to the Gold Standard in 1934 with a standard of $35 per ounce of gold. It was finally after the World War- 2 that the economy was largely affected and there was an immediate need of an international exchange rate system which gave birth to The Bretton Woods System (Swamy and Tavlas, 2001). In order to build upon the post war economic stability situation globally that was in much of crisis after the war and to develop an international monetary system of freely convertible currency, 730 delegates from all the 44 Allied Nations of the world gathered in Bretton Woods, New Hampshire, United States signed a new monetary system which came to be known as Bretton Woods Agreement since it was signed at Bretton Woods and it derived its name from the same (International Monetary Fund, 2009). The Bretton Woods Agreement outlined the rules, regulations and policies to govern an international monetary system. A fixed exchange rate was linked to the United States dollar as United States had emerged as the most powerful country after the Second World War and other countries pegged their currency with the currency of United States ($). Thus, each country maintained an international exchange rate linking its currency with the United States dollar (Kenen, 1993). With the establishment of a new international monetary exchange system at Bretton Woods, it laid down certain important feature which was agreed upon by almost all countries of the word. The salient features of the Bretton Woods Agreement were as follows (Johnson, 1973) Bretton Woods Agreement laid down the foundation of two international bodies namely The International Monetary Fund (IMF) and the creation of World Bank. United States Dollar became the most powerful currency in the world as it was pegged to gold at a fixed rate of $35 per ounce of gold and other countries tied their currency with U.S. dollars. Each country following the Bretton Woods System was solely responsible to maintain its exchange rate with a 1% variance to the adopted fixed par value of dollar by either trading its foreign reserves as necessary to maintain the variance. Bretton Woods system was more of a dollar based exchange rate system with a gold exchange standard. Any country following the system could change its par value only with the approval of the fund members and it was only possible when the country faced disequilibrium in its Balance Of Payments. Any country adopting the Bretton Woods System had to become a member of the same by subscribing the countries gold and currency to the IMF as per the requirement and the rules laid down in the agreement. Thus, maintaining an International Liquidity. The system envisaged the removal of all restrictions on the current account transactions of the country adopting the same. The basic purpose of International Monetary Fund (IMF) was to make a stable exchange rate globally and to provide a borrowing facility to the countries adapting to Bretton Woods System in situations of temporary balance of payment scenarios. Gold was still regarded as an international reserve asset globally as U.S. dollars was pegged with gold. Members of IMF were not allowed to adapt to flexible exchange rate system with Central Bank intervening in the exchange rate market to remove the unnecessary volatility in the exchange rate system. Deflationary policy which was the only choice in the classical gold standard was not only the ultimate choice in scenarios of Balance of Payment scenario, Bretton Woods System allowed devaluation of the country’s currency as well. Thus, we see that the new monetary policy laid down in Bretton Woods Agreement aimed at maintaining an exchange rate within a fixed value and further aimed at maintain an equilibrium in the exchange rates by removing the deficits in cases of Balance of Payment scenarios. The Bretton Woods system worked well for nearly 25 years but it very assumption of fixing the U.S. dollars to a fixed exchange gold rate of $35 ounce started creating problem in the longer run as it failed to take into effect the change in gold’s actual value. Dollar had lost a substantial portion of its purchasing power during the World War-2 and as the European economy tried to backup, it led to a huge draining of the gold reserves of the United States (Roubini and Setser, 2005). There was an increase in the balance of payment deficit in United States and devaluation of U.S. dollars was impossible as dollars played an important role in the Bretton Woods System which further led to problems in maintaining the international liquidity as a result to protect the same many reforms such as increase in the quota of the member nations of IMF and creation of Special Drawing Right (SDR) were introduced to enhance the existing international liquidity (Roubini, 2006). SDR’s were distributed among the member countries on basis of their proportion and could be used if a member county had Balance of Payment difficulty or in case a country wanted to increase its international monetary reserves. However these reforms could not add up much to the requirements and due to huge Balance of Payments deficits, United States was forced to devalue dollars which led to a huge drainage of liquid capital from U.S. Smithsonian Agreement was entered in 1971 to establish a new stable exchange rate to reach equilibrium in the Balance of Payment and dollar was devalued by about 9%, from $35 ounce to $38 ounce and the variance of member countries following Bretton Woods System was fixed at 2.25% to the devalued dollar amount (Rajan and Subramanian. 2004). United States still continued to face huge balance of payments deficit and it suspended the convertibility of dollars into gold. Finally the Bretton Woods System came to a complete end in the year 1973 and was abandoned by all countries of the world. Thus, the major reasons for the breakdown of the Bretton Woods System were too much dependence on dollar and deficit in the Balance of Payment in United States and finally undervaluing of the U.S. dollar to maintain international liquidity and equilibrium in the Balance of Payment globally. After the collapse of The Bretton Woods System in the year 1973, a flexible exchange rate system was allowed acceptable by all members of IMF and gold was no longer regarded as an international reserve asset as it was in case of Gold Standard and Bretton Woods System (McKinnon, 1993). Each country got the freedom to independently lay its macroeconomic policies and can choose a different inflation rate in their country as per the international exchange rate and the purchasing power of the currency of the respective country. It is to be noted by the end of 2001, nearly half of the members of IMF adapted to some form of flexible exchange rate system and this system is still in use in the present scenario where almost all countries of the world had adapted the same. Floating exchange rate has its own significance as it automatically allows a country to dampen the impact of shocks and possibility of Balance of Payment deficit is considerably lowered. The floating exchange rate further promotes economic development of the country as the exchange rates can be changed as per the requirement of the monetary policy of the country. It further promotes international trade freely and increases the international liquidity which was a major problem for the breakdown of the Bretton Woods System as it does not requires an official foreign exchange reserve (Hunt, 2008). One of the significant importance of flexible exchange rate is it is useful in preventing the speculations which was not been able being prevented in the fixed exchange rate system in spite of strict exchange control measures. However, flexible exchange rate has low elasticity since the export and import flexibility is very low as the market exchange rate is unstable which further led to have an adverse effect on the economic structure of a country or economy being operated with flexible exchange rate system. Flexible exchange rates further leads to unnecessary capital movements and has depression effects on the capital movements as it encourages speculative activities and problem of extremely high liquidity problems in the economy (Solomon, 2007). Since each country is free to adapt a different inflation rate this is a serious threat to every country as a high inflation rate in a country encourages a low purchasing power of the currency and depreciation on the domestic price level of the country which leads to depreciation on the external value of a currency in the global macroeconomic environment. International monetary exchange rate had thus had gone through a series of changes as per the requirement of the economy and economical conditions prevailing right from the traditional Gold Standard which was changed to Bretton Woods Agreement in 1944 to the present system of Floating Exchange Rate System (Nurske, 1994). Many reforms and changes were made in the policies laid down by Bretton Woods Agreement to safe guard the same and continue to follow the fixed rate exchange system. But, however, the economy demanded a change in the fixed rate system and finally a shift was made to floating exchange system which is continuously refined as per the economy requirements to maintain equilibrium in the economy. References Hunt, C. (2008). ‘Financial Turmoil and Global Imbalances: the End of Bretton Woods II?’, Reserve Bank of New Zealand, Bulletin, Vol. 71, No. 3, pp. 44-55. International Monetary Fund (2009). ‘Spillovers and Cycles in the Global Economy’. World Economic Outlook, Washington, D.C. Johnson, H. G. (1973). ‘The International Monetary Crisis of 1971’. Journal of Business, Vol. 46, pp. 11-23 Kenen, P. B., (1993). ‘Bretton Woods System’, in P. Newman, M. Milgate and J. Eatwell (eds), The New Palgrave Dictionary of Money and Finance, Vol. 1, London, Macmillan. Meltzer, A. (1991). ‘U.S. Policy in the Bretton Woods Era’, Federal Reserve Bank of St. Louis Review, Vol. 73, pp.54-83. McKinnon, R. (1993). ‘The Rules of the Game: International Money in Historical Perspective’, Journal of Economic Literature, vol. 22, pp. 1-44 Nurske, R. (1994). International Currency Experience, Geneva, League of Nations. Obstfeld, M. (1993). ‘The Adjustment Mechanism’, in M. Bordo and B. Eichengreen (eds), A Retrospective on the Bretton Woods System, Chicago, University of Chicago Press, pp. 201-268. Rajan, R. and Subramanian. A. (2004). ‘Exchange Rate Flexibility Is in Asia’s Interest’, Financial Times, September 26. Roubini, N. (2004). ‘BW2: Are We Back to a New Stable Bretton Woods Regime of Global Fixed Exchange Rates?’, Nouriel Roubini’s Global Economics Blog. Roubini, N. (2006). ‘The BWII Regime: An Unstable Equilibrium Bound to Unravel’, International Economics and Economic Policy, Vol.3, pp. 303-32. Roubini, N. and Setser, B. (2005). ‘Will the Bretton Woods 2 Regime Unravel Soon? 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