Question

what was the Bretton Woods system of Exchange rates? What were it's advantages and disadvantages? What happened after Bretton Woods was abandoned? Can the PPP or Balassa Samuelson Theories explain the short term fluctuations in Exchange rates? How about the long term?

Answer 1

Bretton woods system was used to control the value of currency between several global countries. It essentially meant that each country had a monetary policy which kept its exchange rate within a band in terms of the gold they held. The US dollar was pegged to the price of the gold.

Advantages were that it helped to create a platform to increase the convenience of international trade. It enhanced macroeconomic stability all over the globe. Disadvantages were that the governments had to limit the capital flows so as to instill control, United states was always under pressure to supply the quantity of gold as the rest of the world demanded, but its gold reserves would have declined drastically which could have dented the value of the dollar.

After the Bretton woods was abondoned as the US did not have enough gold to back up the dollar. Each member decided to substitute the dollar in the place of gold, then countries started to peg to the US dollar and several other variants came into place such as flexible and floating exchange rate.

Purchasing power parity uses the prices of certain common goods across countries such as McDonalds burger to compare the purchasing power. PPP or Balassa Samuelson Theories cannot explain short term fluctuations in exchange rate for the simple fact that product prices across countries of a McDonald's burger won't change in one day, it will be done over a long duration as companies take in several factors while changing the prices. But it can predict long run nominal exchange rates as PPP rates are more stable over time and don't vary over short term and they are less affected by tariffs and speculative attacks like exchange rates are.