CFA, Finance, FRM

Bretton Woods Agreement

The Bretton Woods agreement of 1944 is a landmark for a new global monetary system. It replaced the gold standard with the U.S. dollar as the global currency. By doing this, it established America as the dominant power in the world economy. America was the only country with the ability to print dollars after the agreement was signed. The agreement created U.S.-backed organizations like the World Bank and the International Monetary Fund (IMF), that would monitor the new system.

The Bretton Woods Agreement

The Bretton Woods Agreement was developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire by delegates from 44 countries. The effectiveness of the Bretton Woods System came to an end in the early 1970s when President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency. Member countries were obliged to would maintain fixed exchange rates between their currencies and the dollar Under the agreement. The bank would buy up the country’s currency in foreign exchange markets if its currency value became too weak relative to the dollar.

Avoidance of trade wars was agreed by members of the Bretton Woods system. For example, they could regulate their currencies under certain conditions but they wouldn’t lower their currencies strictly to increase trade.

Replacement of the Gold Standard

Most countries followed the gold standard before Bretton Woods meaning that currency would be redeemed for its gold value. After the agreement, the member countries agreed to peg currencies for the US dollar.

But the question is that why the dollars was selected? And here is the reason for it. The US holds almost three-fourths of the world’s supply of gold and no other countries had enough to back the gold replacement. The value of the dollar was 1/35 of an ounce of gold. Bretton allowed the slow transition from gold standard Due to this the demand for dollars increased and caused a discrepancy in the value of a dollar and led to the collapse of the Bretton Woods system after three decades.

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Need for the Agreement

Till World War I, most countries were using the gold standard. However, the gold tie was cut down so as to print the currency needed to pay for war costs. This led to hyperinflation because the supply of money affected the demand and made countries returned to gold standard post-war.

Everything went well until the Great Depression. Investors switched to commodities trading after the 1929 market crash and the gold prices increased which led people to redeem their dollars for gold. Things were made worse by the Federal Reserve when it defended the nation’s gold reserve by raising interest rates. The Bretton Woods gave fixed exchange rates with flexible rules which were exactly opposite to that of the gold standard.

Benefits of Currency Pegging

The Bretton Woods System included 44 delegates from countries in order to regulate and promote international trade across borders. Currency pegs provide currency stabilization for the trade of goods and services as well as financing. Diversion of only 1% was allowed and countries in the Bretton Woods System agreed to a fixed peg against the U.S. dollar. All the countries were required to monitor and maintain their currency pegs which they achieved by using their currency to buy or sell U.S. dollars as needed. The Bretton Woods System stabilized the exchange rate, fostered economic expansion, and helped international trade relations. The IMF holds the currencies reserve of nations with balance-of-payments deficits and maintains the exchange rate, the World Bank provides financial help by lending money for postwar reconstruction and economic initiatives in less-developed countries.

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The Bretton Woods System’s Collapse

With a sudden increase in demand for gold, the London gold market was shut for two weeks. In 1971 the gold supply was inadequate to cover the dollars in circulation. President Richard M. Nixon declared a temporary halt on the dollar’s convertibility into gold for the central bank. By 1973 many currencies started floating against each other and against the U.S. dollar and led to the collapse of the Bretton Woods System.

After the downfall of the Agreement following options were provided for IMF nations:

  1. The currency was allowed to float freely.
  2. Pegging currency to another or group of currencies
  3. Adoption of currency of other countries.
  4. Become a part of monetary union and to participate in the currency bloc.

The Bretton Woods Agreement stills remains a significant event in world financial history and its legacy continues in the form of the IMF and World Bank. The IMF exists as a holder of reserve currencies and the World Bank as a lender of funds to growing and developing economies of the World.

Author: Trushali Hindocha

About the Author:

Trushali completed her graduation in Computer science and engineering, she has worked as Associate Consultant in Atos Syntel for 18 months. She is currently pursuing MMS in Finance from KJ Somaiya Institute of Management Studies and Research, Mumbai. She is also well acquainted with Tableau and programming languages like Python and R for Data Analytics.

 

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