THE BRETTON WOODS AGREEMENT: 1944 TO 1973 Memories of the economic warfare of the interwar years led to an inter-

national conference at Bretton Woods, New Hampshire, in 1944. At the close of World War II there was a desire to reform the international mon-

International Monetary Arrangements 29

dollar (this established the “par” value of each currency and was to ensure parity across currencies). The U.S. dollar was the key currency in the system, and $1 was defined as being equal in value to 1/35 ounce of gold. Since every currency had an implicitly defined gold value, through the link to the dollar, all currencies were linked in a system of fixed exchange rates.

Nations were committed to maintaining the parity value of their currencies within 1 percent of parity. The various central banks were to achieve this goal by buying and selling their currencies (usually against the dollar) on the foreign exchange market. When a country was experiencing difficulty maintaining its parity value because of balance of payments disequilibrium, it could turn to a new institution created at the Bretton Woods Conference: the International Monetary Fund (IMF). The IMF was created to monitor the operation of the system and provide short-term loans to countries experiencing temporary balance of payments difficulties. Such loans are subject to IMF conditions regarding changes in domestic economic policy aimed at restoring balance of payments equilibrium.

FAQ: What Are Special Drawing Rights? There is one odd currency that is priced in any currency table, but does not physically exist, namely the SDR—Special Drawing Right. This “currency” was issued by the International Monetary Fund (IMF), but never existed in physical

form. Instead it has been used as a unit of account for a long time. For example, all of IMF’s own accounts are quoted in SDRs.

The Special Drawing Right (SDR) first appeared in 1969. The SDR was used to support the Bretton Woods fixed exchange rate system. Participating countries in the Bretton Woods agreement needed more official reserves to support the domestic exchange rate. However, at that time, the supply of gold and U.S. dollars was insufficient for the rapid growth of world trade. The SDR provided more liquidity to the world markets and allowed countries to continue to expand trade. The SDR does not exist as notes and coins, but has value because all member countries of the IMF have agreed to accept it.

Allocations of SDRs are rare, and have only happened four times in history. The first allocation was in 1970 72 (SDR 9.3 billion) in the very end of the Bretton Woods system. The next one was in 1979 81 (SDR 12.1 billion). After that no more SDRs were allocated until the Great Recession. In August

28, 2009 SDR 161.2 billion were allocated and 21.5 billion SDRs were allocated

30 International Money and Finance

Valuing the SDR currency

Thursday, May 19, 2011

Currency Currency

U.S. dollar Percent change in amount

Exchange

rate 1 equivalent exchange rate under Rule

against O-1

U.S. dollar from previous calculation

0.147687 21.086 yen Pound

0.179 sterling U.S. dollar

Note: 1 The exchange rate for the Japanese yen is expressed in terms of currency units per U.S.

dollar; other rates are expressed as U.S. dollars per currency unit.

In the case of a fundamental disequilibrium, when the balance of payments problems are not of a temporary nature, a country could apply for permission from the IMF to devalue or revalue its currency. Such a per- manent change in the parity rate of exchange was rare. Table 2.1 sum- marizes the history of exchange rate adjustments over the Bretton Woods period for the major industrial countries.

We notice, then, that the Bretton Woods system, although essentially

a fixed, or pegged, exchange rate system, allowed for changes in exchange rates when economic circumstances warranted such changes. In actuality, the system is best described as an adjustable peg. The system may also be described as a gold exchange standard because the key currency, the dollar, was convertible into gold for official holders of dollars (such as central banks and treasuries).

International Monetary Arrangements 31

Table 2.1 Exchange Rates of the Major Industrial Countries over the Period of the Bretton Woods Agreement Country

Exchange rates a Canada

Floated until May 2, 1962, then pegged at C$1.081 5 $1. Floated again on June 1, 1970.

France No official IMF parity value after 1948 (although the actual rate hovered around FF350 5 $1) until December 29, 1958, when rate fixed at FF493.7 5 $1 (old francs). One year later, rate was FF4.937 5 $1 when new franc (one new franc was equal to 100 old francs) was created. Devaluation to FF5.554 5 $1 on August 10, 1969.

Germany Revalued on March 6, 1961, from DM4.20 5 $1 to DM4.0 5 $1. Revalued to DM3.66 5 $1 on October 26, 1969.

Italy Pegged at Lit625 5 $1 from March 30, 1960, until August 1971. Japan

Pegged at f360 5 $1 until 1971. Netherlands

Pegged at F13.80 5 $1 until March 7, 1961, when revalued at F13.62 5 $1. United Kingdom Devalued from $2.80 5 d1 to $2.40 5 d1 on November 11, 1967.

a Relative to the U.S. dollar.

role in making sure that market pressure did not change the exchange rate. The various central banks achieved this goal by buying and selling their domestic currencies on the foreign exchange market. The central bank intervention can be illustrated using the trade flow model developed in Chapter 1. Assume that the U.S. and the U.K. are trading with each other, and that the U.K. residents start demanding more Fords (a U.S. good). In the first chapter you learned that this would imply a shift in the supply curve for pounds. U.K. traders would be more willing to supply their pounds to banks in exchange for dollars, because the traders want to buy U.S. goods. Banks see more customers supplying pounds and demanding dollars, causing banks to want to depreciate the pound. Figure 2.2 illustrates the shift in the supply curve causing the banks to

32 International Money and Finance

The Market for British Pounds S $/£

Q 1 Q 2 Q 3 Quantities of pound Figure 2.2 Intervention in a fixed exchange rate system.

shows that the Bank of England has to buy a quantity of pounds equivalent to the distance from Q 1 to Q 3 , and sell a quantity of dollars equal to the quantity of pounds multiplied by the 2.00 exchange rate. This action would supply enough dollars to prevent private banks and traders from changing the exchange rate.

Note that the model used to illustrate the intervention is a flow model. This means that each period the situation will occur. For example, if the period is a year, then the excess supply of pounds will exist every year, as long as the new demand for Fords exists. Thus, the Bank of England has to intervene each year and buy pounds and sell dollars. If the excess supply persists too long, the Bank of England may run out of dollars in their vaults, and would be forced to apply for permission from the IMF to devalue their currency to be in line with the new market exchange rate (in this example 1.80).

THE BRETTON WOODS AGREEMENT: 1944 TO 1973 Memories of the economic warfare of the interwar years led to an inter-