The Bretton Woods System of Fixed Exchange Rates - Theoretical Background and its Development

Term Paper , 2006 , 23 Pages , Grade: 1

Economics - Monetary theory and policy

This work is about the international monetary system, which is a called the Bretton Woods System, starting primarily from the end of the Second World War till the the 1970s. First of all the background of the years before the formation of the Bretton Woods System will be disclosed. This is important to evaluate the importance of a reformation of the monetary system. In the chapter “History” you will find further information, first about the Classical Gold Standard before 1914, second about the Gold-Exchange-Standard after the First World War and finally, about the currency confusion in the period from 1931 till the Second World War. In the third chapter of this assignement the Bretton Woods System will be revealed in detail. It starts with the background of the system, the theoretical details like the two proposals for the formation of the system, followed by some important aspects, as well as the main principles. Further points in this chapter are the implementation and the development throughout the years. Last but not least this is followed by a conclusion.

List of Contents

0 Preface

1. Introduction

2. History
2.1 Classical Gold Standard before 1914
2.2 Gold-Exchange-Standard after the First World War
2.3 Currency confusion in the period from 1931 till the Second
World War

3. The Bretton Woods System
3.1 Background
3.2 Bretton Woods
3.3 Theoretical Background: The basic principles
a) Keynes Plan
b) White Plan
c) Convertibility
d) Fixed exchange rates
e) Margin in a system of fixed exchange rates
f) Gold-Exchange-Standard (Gold-Dollar-Standard)
g) Principles of the Bretton Woods Agreement
3.4 Implementation
a) International Monetary Fund (IMF)
b) Drawing Rights
c) International Bank for Reconstruction and Development (IRBD)
3.5 Development till the 1970s
3.6 Conclusion (Advantages and Weaknesses)

4. List of References

5. Appendix

0 Preface

Like single persons need money to make their transactions with other persons, also states need money to make transactions with other states. But the international association is not so good organized like most of the states. The instance is missing which rules what kind of currency is legitimate for all countries in the matter of counterbalancing the debts of the countries.

Instead of this the governments must negotiate and accept an international monetary system. This monetary system must be in the position to meet all the needs of the different countries so that the governments and the single persons can rely on this system.

In long-distance view a country must gain a balance in transactions with other countries, otherwise one will doubt about the countries ability to keep the value of the currency and the position in the world. The government must care through national economic policy as well as in all other political areas - from commercial policy to defence policy – that the country does not become a chronicle debtor.

Governments get quite often automatically and without the supplement of others in financial difficulties. Normally they do not find a way out of this difficulties without the help of other governments. Because of this reason, there is the international monetary system. It is a kind of association for reciprocal aid together with a kind of association for interactive ensuring the system scheme.

1. Introduction

This work is about the international monetary system, which is a called the Bretton Woods System, starting primarily from the end of the Second World War till the the 1970s.

First of all the background of the years before the formation of the Bretton Woods System will be disclosed. This is important to evaluate the importance of a reformation of the monetary system. In the chapter “History” you will find further information, first about the Classical Gold Standard before 1914, second about the Gold-Exchange-Standard after the First World War and finally, about the currency confusion in the period from 1931 till the Second World War.

In the third chapter of this assignement the Bretton Woods System will be revealed in detail. It starts with the background of the system, the theoretical details like the two proposals for the formation of the system, followed by some important aspects, as well as the main principles. Further points in this chapter are the implementation and the development throughout the years. Last but not least this is followed by a conclusion.

2. History

For the understanding of the monetary system it is functional to disclose the way from the Gold Standard over the wars and inflations to the institutions of Bretton Woods and to the power of the Gold-Exchange Standard (Degner, Zweig 1965: 43).

There are three main periods which are useful to reveal for this reflection of the past:

first, the Gold Standard before 1914 (gold currency during the 19th century), that build till the outbreak of the First World War in the year 1914 the basics for the interstate economic commerce, second the Gold-Exchange-Standard, which was introduced after the termination of the First World War and broke down in the year 1931 and finally, the period of the currency confusion starting from 1931 till the occurrence of the Second World War (Günnicker 1967: 41).

2.1 Classical Gold Standard before 1914

Historically gold was used as the currency and monetary unit which corresponded to a certain amount of gold (Zeitfragen 2002). In the period before the First World War gold was the basic for the national monetary system (Hudeczek 1969: 38). In the year 1815 the Allies signed at the “Wiener Kongress” a collection of guidelines for the international finance bearing which are known as the “Rules of the Game” (Weil, Davidson 1971: 12, Guillebaud 1947: 3). These rules gave the framework for economical and political measures (Degner, Zweig 1965: 43, Weltpolitik 2004). With this act the fundamentals of our monetary system were established (Weil, Davidson 1971: 12).

Previsously besides gold also silver was used as a currency but it was later displaced by gold because of two reasons. First of all, the discovery of rich gold treasures in California and Australia in 1848, which created the quantitative premise for the change to the pure gold currency. Secondly, the development of the integration of national economies in the world economy, which was a process that urged a uniform monetary system (Günnicker 1967: 41).

In the historical Gold Standard System the bank notes (inclusive coins) had been linked to gold, whereby the gold price and the ratio of the gold coverage had been fixed by the countries (Goldseiten 2002). The basic rule was a fixed price for gold, which means that each currency was in a fixed proportion to a certain amount of gold (meaning that the value of a local currency was fixed at a set exchange rate to gold ounces) (Zeitwende 2004). The official monetary reserve was gold and the central bank was obliged to hold for the distributed bank notes the prescript gold coverage (Hudeczek 1969: 38). The basic rule was that a country which wants to purchase goods and products from a foreign country has to change those versus own goods and products or has to pay in gold (Weil, Davidson 1971: 12).

The special characteristics of the gold standard were: the convertibility of the internal means of payment in gold at a particular rate and the unrestricted right to import and export gold (Guillebaud 1947: 3). Consequently the exchange rates between the different countries were tied up and the stability of the exchange rates gave the international economic commerce a secure fundament (Günnicker 1967: 43).

2.2 Gold-Exchange-Standard after the First World War

Not only the narrow economic linkages of the big trade and industry nations were destroyed during the First World War but also the Classical Gold Standard. The characteristics of the Gold Standard, as already described, had been abolished (Degner, Zweig 1965: 46). The normal gold and money movements over the boundaries were prevented and so the regulating influence of the balance of payments was abolished (Guillebaud 1947: 4).

As soon as the financial means, which were needed for the war, were scarce and the resources of tax and government bond did not cover the demand of the governments another characteristic of the Gold Standard had been abolished, this means that the coverage regulations for the circulation of the bank notes were modified, which made it possible for the belligerently countries to finance at least a part of the war through the note press (Goldseiten 2005; Kasten 1970: 20). In other words, the governments printed as much money as they needed. Because of this, gold lost in almost every country its function as a regulator of the internal money amount. This resulted in an increasing inflation (Günnicker 1967: 47).

In reference to the concerns of building up and furtherance the world trade a reorganization of the monetary system was needed (Günnicker 1967: 47). In the year 1922 at the conference of Genua the Gold-Exchange-Standard was introduced. This means that besides gold the central banks could also use the money of the victorious power, dollars and pounds, as money reserves (Zeitwende 2005). Dollar and pounds were in this period the same like gold (Goldseiten 2005).

2.3 Currency confusion in the period from 1931 till the Second

World War

The economic boom that had followed the period of reconstruction after the First World War came to an abrupt end with the Wall Street Crash of 24 October 1929, which triggered off the Great Depression. Bankruptcies and skyrocketing unemployment spread from the U.S. to every country in the world (except the USSR where production continued to expand) (Zeitfragen 2002). The causes for this are many-sided. To those belong war reparations and furthermore efforts to insulate their own economies from the worldwide economic drought, and instead of establishing an integrated monetary system the world economy decomposed in many regional currency blocks (Zippel 1978: 52; Weltpolitik 2004). Almost all countries in the world erected trade barriers making export goods to other countries just as impossible as producing for non-existent domestic markets (Marxists 2005). In consequence the expansion of autarchy and bilateralism destroyed in a tremendous extent the work sharing and therewith also the worldwide wealth (Wikipedia 2005).

In the year of 1932 the U.S. President Roosevelt tried to lead the U.S. out of the world crisis through deficit spending (to bring new printed money into circulation and make debts). This means that new devaluated dollar had been brought into circulation. But the problem was not eliminated. The next world war ended this problem. The unemployment rate was abolished because quite a lot of the men had to move into the war and the different companies got contracts from the defense ministry (Marxists 2005; Zeitfragen 2002). As already mentioned above, also the Second World War was mainly financed through the possibility of the governments to finance a part of the war through the note press (Goldseiten 2005). The Gold Standard finally broke down (Kasten 1970: 20).

3. The Bretton Woods System

In this chapter the Bretton Woods System will be revealed in detail. It starts with the background of the system, the two proposals for the formation of the system, some important aspects, followed by the main principles, the implementation as well as the development.

3.1 Background

The monetary regime, reflected in the Bretton Woods Agreement, was a reaction to but also reflected deeply what had gone before it, particularly the Gold Standard as it was understood and the monetary chaos that prevailed on those occasions, immediately following the First World War and again the Great Depression, in which the Gold Standard broke down (Cooper 1987: 23). Moreover it can be understood as a reaction of the period that was marked by competitive currency devaluations and protectionism between the First and Second World War (Jürgen Patzold 2005).

Essential guide line for the ambition to set up a legal monetary system under Bretton Woods was the desire to insure the indisputable advantages of the gold currency of the earlier years, namely fixed exchange rates, protection of the balance of payments stability and the discipline of the central banks concerning monetary policies without having the well-known disadvantages (e. g. closed markets and economic warfare of the 1920s and 1930s) (Bechler 1981: 404). In addition the desire was to get balanced growth of the international trade, high employment, exchange rate stability and the maintaining of organized exchange rate agreements (Aschinger 1978: 12).

The effort to generate global economic stability and increased volumes of global trade, established the basic rules and regulations governing international exchange (Zippel 1978: 52). A lot of different issues had to be discussed: the detention of the exchange rates, including the framework for devaluation and revaluation, the definition of the reserves and the establishment of a credit machinery, upon which deficit countries can lend money which have medium-term problems to keep their balance of payment stabil (Weil, Davidson 1971: 18). With the Bretton Woods System the nations hoped to get all these problems solved.

3.2 Bretton Woods

At the end of World War II, it came to the third and temporarily the last try to introduce a Gold Standard. Under the new leading power, the USA, the Bretton Woods System was established (Goldseiten 2005). Ministers of the U.S., Britain and France and expert representatives of 41 other Allied countries, including the Soviet Union, came together at the Mount Washington Hotel, situated in the town of Bretton Woods, New Hampshire. This meeting was officially known as the United Nations Monetary and Financial Conference (Guillebaud 1947: 8; Marxists 2005). The delegates deliberated upon and finally signed the Bretton Woods Agreement during the first three weeks of July 1944. It became effective at the end of the year 1945 (Zippel 1978: 53).

On the agenda of the conference there were two main intensions: to work out a new international monetary system with more flexibility, in contrast to the old Gold Standard and to promote foreign capital investments through an international investment financing bank (Guillebaud 1947: 9).

Two different reform plans which build the basics for the final agreement had been presented (Bechler 1981: 405). The American Blueprint of the chief international economist at the U.S. Treasury in 1942-1944, Harry Dexter White, and the British Plan from the eminent economist John Maynard Keynes (Weil, Davidson 1971: 19)

The two main principles of the Bretton Woods System were the free convertibility of currency and the concept of fixed exchange rates (with a certain bandwidth) (Zu Eltz 1981: 19). Furthermore gold had again been enshrined as the central value and numeraire of a fixed-parity system (Coombs 1976: 4). Coverage of the currencies should be provided through gold and foreign currency reserves by the central banks. The dollar counted as the foreign currency reserve (Goldseiten 2005). As such, the dollar was fixed to gold and functioned as an anchor to the world’s currency system (Goldseiten 2005) and that was the big difference to the normal Gold Standard (Guillebaud 1947:14).

In this general sense, the Bretton Woods System was an idealized, even a noble, concept of a world financial order under which multilateral trade might florish to the benefit of all (Coombs 1976: 6). In the world history the Bretton Woods System was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states (Wikipedia 2005).

This system, despite the fact that it was modified and shaped by events, remained basic to the international monetary framework until proceedings in the early seventies seemed to show that it was breaking down and was about to be superseded by new provision (Scammel 1977: 108).

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• College: Pforzheim University
• Course: International Economics
• Grade: 1
• Author: Kathrin C. Hägele (Author)
• Publication Year: 2006
• Pages: 23
• Catalog Number: V55003
• ISBN (eBook): 9783638500623
• ISBN (Book): 9783640634378
• Language: English
• Tags: Bretton, Woods, System, Fixed, Exchange, Rates, Theoretical, Background, Development, International, Economics