Important Features of the Bretton Woods Agreement - Essay 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: Type the date here Word Count: 2,057 Introduction The exchange rate of one country in comparison to the currency of another country has an important role in determining the level of international trade. Since, countries have different currency and to engage into business relations it is imperative that the other economy is compensated properly. This has resulted in the development of exchange rate where the currency of one country is measured against another. The currency of one country constantly undergoes fluctuation due to the floating exchange rate system being adopted by the economies. This has made economies develop monetary policies which looks to ensure that the economy grows and is influended by different economic factors like inflation, recession, purchasing power of currency, economic stability andso on. Exchange rate has an influence on these factors and helps to determine the rate at which trading will take place. The exchange rate has also undergone and seen several changes since its start in 1870 where Gold Standards were used. This has constantly changed over a period of time and has given birth to a floating exchange rate system. The changes from the gold standards to the floating exchange rate have been explained under the Bretton Woods System. This paper looks to evaluate the Bretton Woods System where it will look to highlight the reason for the creation of such a system, the different features which the system has and the reasons which led towards its abolishment. This will thereby help to understand the entire process through which the Bretton Woods System and will help to understand the manner in which exchange rate was determined. A brief History The need for an exchange rate system can be found in the year 1879 when the world economies had started to be involved heavily in international trade. This made the world bodies develop a mechanism where the gold standard would be used to determine the exchange rate of the currency. The period of Gold Standard helped the paper currency realize its actual value. Economies which followed the Gold Standards had to ensure that the followed the different rules and regulations which were provided by the Gold Standard. The Gold Standard stated that any economy which had currency of another economy could exchange those currency with the gold reserves of that the country had and could also use their own personal gold reserves to purchase the currency of another country. This process ensured that the currency of the country was backed by the gold reserves which the country had. This ensured that an economy could not have a new currency without having the required gold reserves to back it (Cohen, 2002). The Gold Standard ensured that the economic stability of the country could be achieved and provided the required fundamentals in the financial markets which would help to reduce the financial or economical shock and help in the long term growth and prospect of the economy. The usage of Gold Standard was a success in the beginning but with the passage of time the different gaps and weakness which the system has was exposed. The developed and developing nations slowly with the passage of time started to feel that the amount of paper currency which they possessed was not sufficient to carry on their business transaction and printing new currency was not possible as it would require that the currency had to be pegged and backed by gold reserves. The major impact was felt during the Great Depression of 1930’s and even powerful countries like Britain started to feel the additional pressure which was arising due to the lack of paper currency, which slowly passed on to the other nations and engulfed all world economies. The situation worsened during the First World War when more and more paper currency was required to purchase the different warheads. The already acute shortage of paper currency multiplied the complexities and resulted in a recessionary like conditions (Swamy and Tavlas, 2005). This situation became so grim that finally the world economies had to come together and had to abolish the Gold Standard based on which the exchange rate was determined. Bretton Woods Agreement The abolition of Gold Standard started from Britain in 1914 and other countries followed soon. Still, during the period of 1918 to 1939 the world economies witnessed many ups and downs as at times some of the economies again adopted the Gold Standard and again left which made the period to be termed as Interwar Period (Eichengreen, 2004). The period was so critical that even Britain and US reverted back to the Gold Standard but finally in the year 1931 Great Britain abolished the Gold Standard as the economic condition became unstable after the world war. This was backed by the Great Depression which made countries leave the Gold Standard. The US economy also abolished the Gold Standard but in the year 1934 again adopted the Gold Standard by pegging their currency at $35 per ounce of gold (Bordo, 1993). The poor economic condition led by depression and world war created a huge deficit in the Balance of Payment and finally made economies realize that abolishing the Gold Standard was the only method which would have ensured that the world economies recover and was able to grow (Swamy and Tavlas, 2001). To deal with the loopholes in the Gold Standard and to have a free convertible currency that will look to maintain the required equilibrium in the world economy, a conference of 730 delegates from different allied nations was help Bretton Woods, New Hampshire, United States. The agreement was signed for having a free convertible curreny and came to be known as the Bretton Woods Agreement. Since, at that period of time the US currency i.e. Dollar was the most powerful currency so all the other currencies of the world was pegged against the US dollar and the US dollar was tied to a fixed rate of gold (Roubini and Setser, 2005). This ensured that the exchange rate for all currencies would be determined based on the US dollar and every other economy had to follow and accept the same. Features of Bretton Wood System This brought the Gold Standard to an end and ensured that the Bretton Woods System came into existence the features of the system is as follows To ensure that the international trade and exchange rate had no hurdles the International Monetary Fund and the World Bank was created (Kenen, 1993) The Gold Standard was completely abolished but still gold had its relevance as it was pegged against the US dollar at $35 per ounce and based on it the exchange rate of other countries was determined (Kenen, 1993) Countries which had become a part of the Bretton Woods System has to work against the guidelines of the exchange rate for their currency where 1% variance was allowed either side of the fixed par dollar for trading in its foreign reserves The new method can also be termed as the US based dollar exchange rate as the other countries are dependent of dollar which has been determined on the fixed value of gold (Kenen, 1993) This process helped to deal with the issues that were present due to deficit in the Balance of Payment as the economies were allowed to change their par value after getting the required approval from the IMF (Kenen, 1993) The system helped to improve the liquidity condition as the system required that every economy has to have reserves for 25% of their value of total currency which is traded either in the form of gold or US dollar thereby ensuring that the economy had liquidity within the system (Kenen, 1993) The system didn’t look to have any sort of reserves for contingencies or emergency situation (Kenen, 1993) The system also provided a free trade opportunity as all Current Account Transaction limits were removed and allowed every economy to trade with other The Bretton Woods System also allowed the opportunity to devalue the rate of the currency so that equilibrium could be maintained which was lacking in the Gold Standard and thereby helped to multiply the effectiveness of the Bretton Woods System (Kenen, 1993) The IMF also allowed the member countries to borrow money so that the deficit in the balance of payment could be improved and the economy could achieve the required equilibrium within their economy (Kenen, 1993) The Bretton Woods System was thereby designed in such a manner that it looked to maintain the required equilibrium, ensure sufficient liquidity within the economy and helped to remove the problems which were faced due to deficiency in the Balance of Payment (Dooley, Folkerts-Landau and Garber, 2004). Despite the different advantage that the Bretton Woods System it also started to highlight the different issues which it had. The fact that the Bretton Woods System which was based on US dollar was pegged against gold created problems as the value of gold was constantly changing and instead the currency was pegged at $35 per ounce of gold thereby creating a gap which could give rise to speculation activities (Hunt, 2008). This was matched by the fact that devaluing the value of US dollar was not possible as other currencies were pegged against it and on the other hand US economy was increasing a rapid rise in their deficit in balance of payment. This was matched by the fact that the value of US dollar was decreasing continuously which had resulted in the creation of inflationary condition in US as prices of different commodities started to go up. The problem compounded during the Second World War when different economies started to strengthen their gold reserves by exchanging it for US dollar which created a huge liquidity crunch in the US (Solomon, 2007). Breakdown of Bretton Wood System To deal with the complex issues which the world economies were facing several changes were made to the Bretton Woods System. On the first instance more and more members were inducted into the system so that liquidity could be generated. Reforms was made by introducing the Special Drawing Rights (SDR) were distributed among the members on the basis of proportion and the same could be used by the holder to increase its monetary reserve in the country or to maintain an equilibrium in cases of deficit Balance of Payment situations (Bordo and Eichengreen, 2008). Despite the different efforts the liquidity problems continued and finally the US dollar had to be devalued by 9% resulting in an increase in the value of dollar to $38 against per ounce of gold. This also brought the changes in the variance as it increased to 2.25% from the previously 1%. This resulted in unrest in US as it resulted in huge money to be drained off from the system through interest rates and finally the US economy had to suspend the convertibility of dollar into gold which thereby ended the Bretton Woods System in the year 1973. The Bretton Woods System was replaced when all the economies met at Jamiaca and decided that the fixed exchange rate which was adopted by the world economies was to be replaced by a floating exchange rate (Hunt, 2008). The floating exchange rate would look at ensuring that the value of currency would fluctuate as the market fundamentals would determine the exchange rate and was finally signed leading to the Jamaica agreement which resulted in the abolition of the Bretton Woods System. The prime reason which led to the failure of the Bretton Woods System was the over reliance on US dollar, the huge deficit in the Balance of Payment, liquidity crunch and the proposal to have a fixed value of gold which would lead to speculation activities as the changes in the value of gold would result so (Dooley, Folkerts-Landau and Garber, 2005). This made the IMF bring major ramification and removed the fixed exchange rate with the floating exchange rate where the market fundamentals determined the value of the currency and fluctuating value of gold. The development of the floating exchange rate would provide different advantage as it would help to reduce the financial shocks and ensure that the organization is able to deal with the deficit in the balance of Payment in the most productive manner (Roubini, 2006). This provided an opportunity where the economies could develop their own monetary policies based on the international policies and ensure that the different shocks reduces Conclusion Thus, the exchange rate which stated with the Gold Standard was followed by the Bretton Woods System and finally the adoption of the floating exchange rate to determine the value of the currency with respect to the currency of another economy has helped to reduce shocks and generate the required liquidity. This has thereby raised the work load on IMF and World Bank as they have to monitor the activities and ensure that speculation activities are curtailed which will thereby help to provide a correct exchange rate for all currencies around the world. 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, 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. (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. (2004). ‘The Revived Bretton Woods System’, International Journal of Finance and Economics, Vol. 9, pp. 307-313 Eichengreen, B. (2004). ‘Global Imbalances and the Lessons of Bretton Woods’, NBER Working Paper 10497. Hunt, C. (2008). Financial Turmoil and Global Imbalances: the End of Bretton Woods II? Reserve Bank of New Zealand, Bulletin, 71 (3), 44-55 Kenen, P. B., (1993). ‘Bretton Woods System’, in P. Newman, M. Milgate and J. Eatwell (eds), The New Palgrave Dictionary of Money and Finance, 1, London, Macmillan. 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? The Risk of a Hard Landing in 2005-2006’, Federal Reserve Bank of San Fransisco Symposium on Revived Bretton Woods System: A New Paradigm for Asian Development? Solomon, R. (2007). The International Monetary System, 1945-1976: An Insider’s View. 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