Classic gold standard: 1875-1914 Gold alone is assured of unrestricted coinage There is a two-way convertibility between gold and national

currencies at a stable ratio Gold may be freely exported and imported The gold standard provided a 40 year period of

unprecedented stability of exchange rates which served to promote international trade (U.S. dollar to pound exchange rate remained in a $4.84-4.90 range!).

Interwar period: 1915-1944 Trade in gold broke down, and countries started to “cheat.”

Bretton Woods system: 1945-1972 U.S. dollar was pegged to gold at $35.00/oz. Other major currencies established par values against the

dollar. Deviations of ±1% were allowed, and devaluations could be negotiated.

The Monetary System

The key role of gold in the Bretton Woods system was connected to the convertibilty of the U.S dollar into gold at a fixed price. This meant that the United States stood ready to sell gold to foreign central banks, but not to private citizens in exchange for U.S.dollars at a fixed price of $35 per ounce.

The Bretton Woods system operated on the basis of a gold exchange standard. Under a gold exchange standard, countries are expected to redeem their currencies into convertible currencies ( but not necessarily in the form of gold itself).

Under Bretton Woods, most central banks kept a large part of their international reserves in the form of dollar denominated assets, such as dollar deposits or U.S. Treasury bills. The dollar became the system’s main reserve currency, a role it had been chipping away from the pound sterling ever since World War 1.

Exchange rates were maintained within the narrow limits allowed by the IMF by means of central bank intervention in foreign exchange markets.

The U S $ played a predominant role here because it was used as an intervention currency by foreign central banks.

In a nutshell, the Bretton Woods system was an adjustable peg regime operating under a gold exchange standard in which most currencies were convertible into U.S. dollar and the dollar, in turn, was convertible into gold.

The Economic Experience under Bretton Woods

The generally low levels of international reserves held by the major foreign industrial countries after the war and their large trade deficits with the United States became associated with a massive dollar shortage abroad and with acute balance-of-payments difficulties for those countries in the late 1940s and 1950s.

As a result, most European countries maintained a range of capital controls throughout the 1950s.

It was not until 1958 that their currencies really became fully convertible to the dollar.

In the 1950s, the U.S. began to show substantial deficits on an official reserve settlement basis, a pattern that persisted and depreciated during the next decade.

The increasing supply of dollars abroad was accompanied by a rapidly shrinking stock of U.S. gold reserves.

In the face of growing purchases of gold on the part of foreign banks and private citizens, the gold convertibility of the U.S dollar was threatened.

The Bretton Woods system literally collapsed in 1971. With rampant expectations that an increase in the dollar price of gold was imminent and that a major devaluation of the dollar vi-a-vis most other major currencies was soon forthcoming, the resulting speculative run on the dollar bacame unsustainable.

In May 1971, in the face of massive short-term capital inflows associated with speculation against the dollar, Germany decided to its currency float vis-à-vis the dollar. The Netherlands followed suit, and Switzerland and Austria also both revalued their currencies.

Early in 1973, the major European currencies and the Japanese yen started floating vis-a –vis dollar.

The Bretton Woods system operated well while it lasted. It supported a flourishing regime of international trade and finance, with stability and relatively high growth rates, by historical standards, and with relatively low unemployment and inflation rates. Given this record, and taking into account that the period from 1971 to 1973 was not directly connected to any major war involving the European industrial countries, the collpse of the Bretton Woods system appears paradoxical. Nevertheless, its history shows a number of basic problems.

Why did it( BWS) fail?

The absence of external payments adjustment steps on the part of the U.S. meant that non-reserve currencies had the burden of adjustment under BWS.

European countries and Japan had to subjugate their policy attention toward external balance.

When the supply of dollars in 1970 and 1971 exploded, straining to its limits the internal goals of price stability in non-reserve currency countries, the latter reacted by converting dollars into gold, sterilizing increases in reserves and finally , by letting their currencies float vis-à-vis the dollar.

The inconsistency of the explosion in international liquidity with the national policy autonomy and goals of non-reserve currency countries finally pushed the Bretton Woods system into collapse.

Broad Real US dollar IndexSource: www.federalreserve.gov

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0The Monetary System

Jamaica Agreement (1976) Central banks were allowed to intervene in the foreign exchange

markets to iron out unwarranted volatilities. Gold was officially abandoned as an international reserve asset.

Half of the IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations.

Non-oil exporting countries and less-developed countries were given greater access to IMF funds.

Plaza Accord (1985) G-5 countries (France, Japan, Germany, the U.K., and the U.S.)

agreed that it would be desirable for the U.S. dollar to depreciate. Louvre Accord (1987)

G-7 countries (Canada and Italy were added) would cooperate to achieve greater exchange rate stability.

G-7 countries agreed to more closely consult and coordinate their macroeconomic policies.

The Monetary System

48 major currencies, such as the U.S. dollar, the Japanese yen, the Euro, and the British pound are determined largely by market forces.

25 countries, including the Czech Republic, Russia, and Singapore, adopt some forms of “Managed Floating” system.

37 countries do not have their own national currencies! 8 countries, including China, Hong Kong, and Estonia, do have

their own currencies, but they maintain a peg to the U.S. dollar or the Euro.

The remaining countries have some mixture of fixed and floating exchange-rate regimes.

Current Exchange Rate Arrangements

Product of the desire to create a more integrated European economy.

Eleven European countries adopted the Euro on January 1, 1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy,

Luxembourg, Netherlands, Portugal, and Spain.

The following countries opted out initially: Denmark, Greece, Sweden, and the U.K.

Greece adopted the Euro in 2002.

The Euro

Think about: Potential benefits and costs of adopting the euro. Economic and political constraints facing the country. The potential impact of British adoption of the euro on

the international financial system, including the role of the U.S. dollar.

The implications for the value of the euro of expanding the EU to include, e.g., Eastern European countries.

Will the UK (Sweden) join the Euro?

The FX market is a two-tiered market:

Interbank Market (Wholesale) Accounts for about 82% of FX trading volume—mostly

speculative or arbitrage transactions About 100-200 international banks worldwide stand ready to

make a market in foreign exchange Non-bank dealers account for 19% of the interbank market FX brokers match buy and sell orders but do not carry

inventory and FX specialists

Client Market (Retail) Accounts for about 18% of FX trading volume

Market participants include international banks, their customers, non-bank dealers, FX brokers, and central banks

The Foreign Exchange Market