The International Monetary System

The Rise and Fall of Bretton Woods, the Case of Floating Exchange Rates and the Phenomenon of Bretton Woods II


Project Report, 2011

24 Pages, Grade: 1,0


Excerpt

Table of Contents

Executive Summary

List of Figures

1. Introduction

2. History
2.1 The Gold Standard 1870 -1914
2.2 The Interwar Years 1918-1939

3. Bretton Woods
3.1 1944 agreement
3.2 Policy Options under the Bretton Woods System
3.2.1 Maintaining Internal Balance
3.2.2 Maintaining External Balance
3.3 The Fall Bretton Woods

4. The Case of Floating Exchange Rates
4.1 Arguments in favor of floating exchange rates
4.2 Arguments against floating exchange rates

5. Bretton Woods II

6. Lessons learned from Bretton Woods - Conclusion

References

Executive Summary

The international monetary system went through substantial changes during the last century.1

Beginning with the gold standard in 1870 and continuing with the Bretton Woods System until 1973, fixed exchange rate systems generally dominated the world economy for over 100 years.

However, in both cases these systems collapsed after a relatively short period of time. And there are similarities between the breakdowns of these monetary orders. It is a matter of fact, that the abandoning of general rules - i.e. endangering price stability and convertibility by printing money in order to raise funds for military operations - undermined the system´s foundation.

The policy tool of monetary policy is one controversial subject to discussions between advocates and opponents of the main two world monetary orders - fixed and floating exchange rate systems.

During Bretton Woods the absence of monetary policy options amongst 43 of 44 member countries developed to a stumbling block for the whole system as they failed to attain internal and external balance. Furthermore the fact that only the country providing the reserve currency - the United States of America - could apply that policy can be seen as a major error in the system´s design.

The last quarter of the 20th century was shaped by floating exchange rates. But also in the 21st century´s world economic order there are weaknesses to be found that enable similar negative developments like back than in the final period of Bretton Woods. China and the USA which are today under an inofficial second Bretton Woods System experience similar difficulties such as countries did back than during Bretton Woods.

There is no final judgment to be made if a floating or a fixed exchange rate system is the better functioning monetary order. However, if governments within a monetary system cooperate and make their decisions in the interest of all member countries, a floating exchange rate system is more likely to guarantee free trade and international prosperity.

List of Figures

Figure 1: “Four Zones of Economic Discomfort”, adapted from Paul R. Krugman, Maurice Obstfeld, „International Economics - Theory and Policy“, 8th Edition, Pearson, 2009,

Figure 2: “Policies to Bring About Internal and External Balance”, adapted from Paul R. Krugman, Maurice Obstfeld, „International Economics - Theory and Policy“, 8th Edition, Pearson, 2009,

Figure 3: “Government Purchases Growth Rate”, adapted from adapted from Paul R. Krugman, Maurice Obstfeld, „International Economics - Theory and Policy“, 8th Edition, Pearson, 2009,

Figure 4: “Inflation Rate”, adapted from Paul R. Krugman, Maurice Obstfeld, „International Economics - Theory and Policy“, 8th Edition, Pearson, 2009,

Figure 5: “Current Account Surplus”, adapted from Paul R. Krugman, Maurice Obstfeld, „International Economics - Theory and Policy“, 8th Edition, Pearson, 2009,

Figure 6: “Self insured”, adapted from The Economist: http://www.economist.com/node/17414511?story_id=17414511

Figure 7: “Holding Operations”, adapted from The Economist http://www.economist.com/node/17414511?story_id=17414511

1. Introduction

The international monetary system is the framework that unifies individual economies in the modern world. Its function is to guarantee regulation and stability, to settle financial embarrassment and to provide international monetary resources in case of economic disruptions within the system. (Eichengreen, 2000)

Without understanding how the international monetary order works it is impossible to comprehend the mechanisms of the world economic system. This term paper therefore describes the history of the international monetary system from 1870 up to 1973. Additionally it examines the advantages and disadvantages of an alternative floating exchange rate system, as well as the phenomenon of the so called Bretton Woods II between China and the USA.

Before World War I, there was no official supervision of international financial transactions thus international capital flows were on a high level. During the interwar years this gold standard system collapsed, worldwide restrictions on financial transactions were imposed and capital flows as well as international trade decreased considerably. After the Second World War the fixed exchange rate system of Bretton Woods determined the international economy. International capital flows and trade recovered and governments could pursue certain goals on the domestic front without destabilizing their exchange rate. However, the last period of the quarter-century after World War II was also characterized by a high capital mobility and expanding money supply. Whilst maintaining the fixed exchange rates became more and more expensive, the difficulties of adjusting them intensified simultaneously. The inevitable consequence of this development was the breakdown of Bretton Woods and the transition to floating exchange rates. (Eichengreen, 2000; Krugman, Obstfeld, 2009)

Remarkably, some parts of this era are happening again in our world economy today, in a smaller scale however. The economic situation between China and the United States of America presents similarities to the former Bretton Woods system. China is fixing the Yuan against the dollar and profits from it but on the other hand it also experiences the same negative effects that European countries did in the early 1970s. (Wirtschaftswoche, 2011)

On the basis of all these facts it is obvious that the development of the international monetary system is an extraordinary historical process. Also the current monetary policy is affected by former monetary decisions. Neither the current world economic status nor future prospects of this constantly changing order can be examined without understanding its history.

2. History

2.1 The Gold Standard 1870 -1914

The gold standard was based on the ancient use of gold coins as an instrument of trading and storage of value.

In this monetary system a nation´s currency was linked to the value of gold. Thus the exchange rate of that currency was determined by gold. In 1819 this type of international monetary system became a legal institution. The therefore necessary process was conducted by the British Parliament as it cancelled the long-standing restrictions on the export of gold, called the Resumption Act.

In the late 19th century other countries such as Germany and Japan also introduced the gold standard. Back then Britain was the leading economic power in the world and other countries hoped to improve their own economy by imitating the British system. In 1879 the United States joined the gold standard when they linked their paper dollar bills which were issued during the civil war, to gold. This was the main reason why Britain became the international monetary system´s center.

As prices of currencies were fixed in terms of gold, the gold standard attempted to ensure stability in world price levels. In fact price levels did not rise as much as during the gold standard as after World War II. However there was much fluctuation in national price levels over short periods. This was due to a change in the relative prices of gold and other commodities. (The Economist, 2011, URL 1; Krugman, Obstfeld, 2009; Eichengreen, 2000)

2.2 The Interwar Years 1918-1939

During World War I governments more or less suspended the gold standard and printed money in order to finance their substantial military expenditures. Therefore many countries experienced runaway inflation and as a result money supplies and price levels of many countries increased considerably.

In the following years many countries such as the USA, Britain, France, Italy and Japan returned to the gold standard. However, particularly Britain, the former international center of the gold standard system, had problems to reintroduce it. The pound price of gold was too high and the Bank of England was therefore forced to follow a contractionary monetary policy in order to devalue it to the level before World War I. Unfortunately these measures led to a heavy increase of unemployed people. These events led to a decline of London as the world financial center.

Furthermore it proved to be a problem for the stability of the gold standard. Many countries held deposits in London but Britain´s gold reserves were limited. In 1929 the Great Depression began with many bank failures all over the world. The global panic led to a shrinking confidence of foreign sterling deposit holders in the British government´s promise to maintain the currency´s value. Therefore many of them started exchanging their pounds into gold what forced the British representatives to quit the gold standard as they were unable to provide such a huge amount of gold. During the ongoing recession many counties left the gold standard as well and allowed their currency´s price to be determined by floating on the foreign exchange market. The United States left the gold standard in 1933 but returned to it in 1934, other countries did not and suffered most during the Great Depression. Restrictions on international trade and payments imposed by individual countries harmed world economy additionally and the world therefore developed into increasingly self-sufficient national entities in the early 1930s. Due to the Great Depression, many countries had reduced their international trade activities which resulted in lower gains from trade and contributed to a slow recovery from the economic slump. It is a matter of fact that all countries would have benefited from free international trade if international corporation between economies had eased preserving each country´s external balance. (Krugman, Obstfeld, 2009; Eichengreen. 2000)

In the end this conclusion was the basis for the postwar international monetary system, the 1944 Bretton Woods agreement.

3. Bretton Woods

3.1 1944 agreement

The Bretton Woods agreement was drafted and signed in the year 1944 when representatives of 44 countries met in the city of Bretton Woods, New Hampshire, USA. Moreover this agreement was the cornerstone of the International Monetary Fund (IMF) and the World Bank.

In remembrance of the disastrous aftermath of the years between the two world wars, the aim of the participants was to design a new international monetary system that would encourage full employment and price stability under condition that each country could obtain external balance without having trade restrictions. This should be conducted with support of the IMF if necessary. Additionally a second institution, the World Bank was founded. It should support nations in war to rebuild their destroyed economies and furthermore it should help former colonies to develop and modernize their own economies.

The result of the conference was a system which was based on a fixed dollar price of $35 per ounce. Consequently the exchange rates of other country´s currencies were fixed against that dollar price. The participants of the system preserved their financial reserves mainly in the form of gold or dollar deposits and they had the guarantee that their dollar assets would be bought by the U.S. Federal Reserve Bank at the official price in return for gold. Hence, the system was a gold exchange standard in which the dollar represented the main reserve currency.

By setting up this system with parts of discipline and flexibility the articles of the 1944 IMF agreement tried to avoid a second global depression such as in the interwar years. (Krugman, Obstfeld, 2009)

The basis for disciplined monetary management was the fact that exchange rates were fixed to the US dollar which subsequently was bound to gold. It was agreed upon that the exchange rates of IMF members would be pegged to the dollar, with a maximum variation of 1% either side of the agreed rate (The economist online, 2011, URL 2). The result of this rule was that if central banks other than the Federal Reserve conducted an excessive monetary policy, it would forfeit international reserves and therefore become unable to preserve the fixed exchange rate against the dollar. There was even a constraint for the Fed itself since excessive US monetary easing would cause a dollar accumulation by foreign central banks which would result in an incapacity of the Fed to repurchase those dollars in return for gold. Moreover the official gold price of $35 per ounce represented a further barrier for an expansive US monetary policy as such a policy would lead to an increase of the dollar-gold ratio per ounce.

However, guaranteeing monetary discipline was not the only goal of the architects of the Bretton Woods system which they tackled with fixed exchange rates. Additionally, these fixed exchange rates should prevent speculation against one nation´s currency which was seen as the main failure of previous floating exchange rates. (Eichengreen, 2000)

As countries considered full employment to be a major economic goal after the Great Depression, the IMF agreement tried to enable its members to achieve external balance without sacrificing internal objectives or fixed exchange rates. This was realized by pooling currencies and gold of all member states in order to enable the IMF to lend these financial resources to member states if necessary. Also devaluations and revaluations of the currencies against the dollar were possible in cases of an economy in fundamental disequilibrium (Krugman, Obstfeld, 2009, p.516), and if the IMF would have agreed to these measures. The term fundamental disequilibrium describes the case of an economy that suffers from ongoing negative developments in its demand level which would lead to continuous severe unemployment and external deficits without devaluating its currency. (Krugman, Obstfeld, 2009)

3.2 Policy Options under the Bretton Woods System

In the following paragraph it is refered to Krugman and Obstfeld´s International Economics, 8th Edition (2009), p.518 - 525.

The basis for an analysis of the policy options under the Bretton Woods System is the following:

The USA was able to adjust fiscal and monetary policy measures, whereas the other countries only had the opportunity to use fiscal policy options, i.e. to increase government spending or to reduce taxes. Theoretically they had also the option to adjust their exchange rates. However, this was considered as an exception of the Bretton Woods rules and therefore impractical. Countries that made use of this option in order to achieve internal and external balance suffered from balance of payments crises. A balance of payment crisis occurs for example when the market expects a devaluation of the currency by the central bank. Due to speculation, private capital is transferred abroad which leads to a decrease in foreign reserves and the domestic interest rate rises above the world interest rate level.

As already mentioned above, the major goal of countries was to attain internal and external balance. Internal balance is defined as full employment and price level stability whereas external balance is defined as a country´s optimal level of the current account. The target value can be defined as a current account deficit or surplus. Both can lead to problems. A current account deficit undermines foreign investors´ confidence and on the other hand a surplus results in lower investment levels and foreign-policy problems.

To analyze the situation of an individual country except of the USA, it is assumed that domestic interest rates (R) and foreign interest rates (R*) remain equal, as well as the levels of domestic (P) and foreign (P*) prices, as this analysis applies to the short term. Although it does not reflect the Bretton Woods situation a hundred percent, the model will show how dependent the countries were on their fixed exchange rate levels (E) and their fiscal policies.

[...]


1 References can be found in the main part of the paper

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Details

Title
The International Monetary System
Subtitle
The Rise and Fall of Bretton Woods, the Case of Floating Exchange Rates and the Phenomenon of Bretton Woods II
College
Heilbronn University
Grade
1,0
Author
Year
2011
Pages
24
Catalog Number
V191490
ISBN (eBook)
9783656165330
ISBN (Book)
9783656165408
File size
1215 KB
Language
English
Notes
Tags
international, monetary, system, rise, fall, bretton, woods, case, floating, exchange, rates, phenomenon
Quote paper
Dennis Pfeiffer (Author), 2011, The International Monetary System, Munich, GRIN Verlag, https://www.grin.com/document/191490

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