Exchange Rates Systems
Now that we have analyzed the highlights of exchange rates and of the international monetary system, we will survey the history of international economic institutions along with current problems of the international economy. standard, the Bretton Woods svstem established a parity for each currency in terms of both the US. dollar and gold. As the key or reserve currency, the parity of the dollar was pegged only in terms of gold, initially at $35 per ounce of gold. Other currencies were defined in terms of both gold and the dollar. For example, the parity of the British pound was set at £725 per ounce of gold. Given the gold price of the dollar, this implied an official exchange rate between the dollar and the pound of $35/£125 = 52.80 per £l, which was thereby set as the official parity on the pound. Under the Bretton Woods system, therefore, because each currency's parity was established in* terms of gold and the dollar, a set of exchange rates among currencies was fixed by international agreement. However, when one currency got too far out of line with its appropriate or "fundamental" value, the parity could be adjusted. The German mark iias adjusted upward, or revalued, on several occasions, while the British pound was devalued from S2B0 per £1 to 52.40 per £1 in 1967. The ability to adjust exchange rates when fundamental disequilbrium arose was the central distinction between the Bretton Woods system and the gold standard. The Bretton Woods system was a fixed but adjustable exchange-rate system. Ideally, exchange-rate changes would be 'worked out among countries in a cooperative way. By creating a fixed but adjustable system, the designers of Bretton Woods hoped to have the best of two worlds. They could maintain the stability of the gold standard, a world in which exchange rates would be predictable from one month to the next, thereby encouraging trade and capital flows. At the same time, they would simulate the adaptability of flexible exchange rates, under which persistent relative price differences among countries could be adjusted to bv exchange-rate changes rather than by the painful deflation and unemployment necessary under the gold standard.
Building International Institutions after World War 1I
After World War II, the United States emerged with its economy intact and was able to help rebuild the countries of allies and foes alike. The postwar international political system also responded to the needs of war-torn nations by constructing durable institutions within which the international economy could recover quickly. The four major economic institutions of the 1940s-the GATT (described in Chapter 37), the Bretton Woods exchange-rate system, the International Monetary Fund, and the World Bank-stand as monuments to wise and farsighted statecraft.
The Bretton Woods System
The economic and social turmoil of the 1930s deeply impressed economic thinkers of the 1940s. They were determined to avoid the economic chaos and competitive devaluations of the Great Depression. In order to- map out a new international economic order, the United States, Britain, and their major allies gathered in Bretton Woods, New Hampshire, in 1944. Under the intellectual leadership of J. M. Keynes and the American diplomat H. D. White, this landmark conference hammered out an agreement that led to the formation of the International Monetary Fund (IMF), the World Bank, and the Bretton Woods exchange-rate system. For the first time in history, nations agreed upon a system for regulating international financial transactions. Even though some of the rules have changed since 1944, the institutions established at Bretton Woods continue to play a critical role today. The conference designed a framework for managing exchange rates that is known as the Bretton Woods svstem. Those who attended the Bretton Woods conference remembered well how the gold standard was too inflexible and served to deepen economic crises. To replace the gold
The International Monetary Fund (IMF)
Another major contribution of the Bretton Woods conference was the establishment of the International Monetary Fund for (or IMF) which still administers the international monetary system and operates as a central bank for central banks. Member nations subscribe by lending their
currencies to the IMF: the IMF then relends these funds to help countries in balance-of-payments difficulties. In recent vears, the IMF has played a key role in organizing a cooperative response to the international debt crisis and in helping socialist countries make the transition to the market. How would an IMF mission operate? Suppose that Poland's program to introduce a market economy is in trouble because of a rapid inflation. It is having trouble paving interest and principal on its foreign loans. The IMF might send a team of specialists to pore over the country's books. The h\IF team would came up with an austerity plan for Po land, generally involving reducing the budget deficit and tightening credit; these measures would slow GNP growth and reduce the trade deficit. IMF would lend money to Poland, perhaps S1 billion, to 'bridge" the country over until its balance of payments improves. In addition, there would probably be a "debt rescheduling," wherein banks lend more funds and stretch out existing loans. If the IMF program was successful, Poland's balance of payments would soon regain health, and the country would resume economic growth.
lower, because the foreign capital has raised GNP in the borrowing countries.
Demise of the Bretton Woods System
For the first three decades after World War II, the world was on a dollar standard. The US. dollar was the key currency; most international trade and finance were carried out in dollars and payments were most often made in dollars. Exchange-rate parities were set in dollar terms, and private and government reserves were kept in dollar balances. The world economy thrived during this period. The industrial nations began to lower trade barriers and to make all their currencies freelv convertible. The economies of Western Europe and East Asia recovered / When Poland and the IMF agree on the plan, the from war damage and grew at spectacular rates. But recovery contained the seeds of its own destruction. Dollars began to pile up abroad as German ,,, and Japan developed trade surpluses. Meanwhile, US. deficits were fueled bv an overvalued currencv, trade deficits, and growing overseas investment bv American firms. Dollar holdings abroad grew from next to nothing in 1945 to 550 billion in the early 1970s. Bv 1971, the amount of liquid dollar balances had become so large that governments had difficulty defending the official parities. People began to lose confidence in the "almighty dollar." And the lower har,iers to capital flows meant that billions of do) could cross the Atlantic in minutes. In August 10, -1, President Nixon formally severed the link between the dollar and gold, bringing the Bretton Woods era to an end. No longer would the United -states automatically convert dollars into other currencies or into gold at S35 per ounce; no longer would the United States set an official parity of the dollar and then defend this exchange rate at all costs. As the United States abandoned the Bretton Woods Svstem, the world moved into the modem era of managed flexible exchange rates.
The World Bank
The Bretton Woods conference also established the World Bank. The Bank is capitalized by lending nations who subscribe in proportion to their economic importance in terms of GNP and other factors. The Bank makes low-interest loans to countries for projects that are economically sound but cannot get private-sector financing. As a result of such long-term loans, goods and services flow from the advanced nations to developing countries. In recent years, the World Bank has made new loans averaging 525 billion per year. While the loans are being spent, the advanced world is forgoing domestic spending. When the loans are being "serviced" or repaid, the advanced nations can enjoy somewhat higher imports of useful goods. Production in the borrowing lands will have risen by more than enough to pay interest on the loans; wages and living standards generally will be higher, not