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In: Economics

Explain the basic operation and decline of the Bretton Woods system.

Explain the basic operation and decline of the Bretton Woods system.

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Expert Solution

The Bretton Woods system was a remarkable achievement of global coordination. It established the U.S. dollar as the global currency, taking the world off of the gold standard. It created the World Bank and the International Monetary Fund. These two global organizations would monitor the new system.

Bretton Woods established America as the dominant power behind these two organizations and the world economy. That's because it replaced the gold standard with the U.S. dollar. After the agreement was signed, America was the only country with the ability to print dollars.

The Bretton Woods Agreement

The Bretton Woods agreement was created in a 1944 conference of all of the World War II Allied nations. It took place in Bretton Woods, New Hampshire. Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar. How exactly would they do this? If a country's currency value became too weak relative to the dollar, the bank would buy up its currency in foreign exchange markets. That would decrease the supply, which would raise the price. If its currency became too high, the bank would print more. That would increase the supply and lower its price.

Members of the Bretton Woods system agreed to avoid any trade warfare. For example, they wouldn't lower their currencies strictly to increase trade. But they could regulate their currencies under certain conditions. For example, they could take action if foreign direct investment began to destabilize their economies. They could also adjust their currency values to rebuild after a war.

Until World War I, most countries were on the gold standard. But they went off so they could print the currency needed to pay for their war costs. It caused hyperinflation, as the supply of money overwhelmed the demand. The value of money fell so dramatically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread. After the war, countries returned to the safety of the gold standard.

All went well until the Great Depression. After the 1929 stock market crash, investors switched to forex trading and commodities. It drove up the price of gold, resulting in people redeeming their dollars for gold. The Federal Reserve made things worse by defending the nation's gold reserve by raising interest rates. It's no wonder that countries were ready to abandon a pure gold standard.

The Bretton Woods system gave nations more flexibility than a strict adherence to the gold standard, but less volatility than no standard at all. A member country still retained the ability to alter its currency's value if needed to correct a "fundamental disequilibrium" in its current account balance.

decline of bretton woods system

In 1971, the United States was suffering from massive stagflation. That's a deadly combination of inflation and recession. It was partly a result of the dollar's role as a global currency. In response, President Nixon started to deflate the dollar's value in gold. Nixon revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce. But the plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of the dollar from gold altogether. Without price controls, gold quickly shot up to $120 per ounce in the free market. The Bretton Woods system was over.


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