Bretton Woods Agreement Explained

The Bretton Woods system was established after World War II and existed between 1945 and 1972. In 1944, representatives of 44 nations met in Bretton Woods, New Hampshire, and designed a new post-war international monetary system. This system advocated the introduction of a stock market standard including both gold and currencies. Under this system, each country has set a nominal value against the U.S. dollar, tied to gold at $35 per ounce. Under this system, the reserve currency country would aim to maintain a balance of payments deficit (BOP) to replenish reserves. If such deficits were to be very large, the reserve currency itself would experience a crisis. This situation has often been described as the paradox of encounter. Finally, in the early 1970s, the gold standard system collapsed for these reasons.

Beginning in 1950, the United States faced trade deficit problems. With the evolution of the euro markets, there have been huge outflows of dollars. The U.S. government has taken several dollar defense measures, including the introduction of the Interest Compensation Tax (EIT) on foreign stock purchases in the United States, to prevent dollar outflows. The International Monetary Fund created a new foreign exchange reserve called Special Drawing Rights (SDRs) to reduce pressure on the dollar, which was the central reserve currency. Originally, SDRs were modelled as a weighted average of 16 currencies of these countries, whose share in world exports was greater than 1%. In 1981, the SDRs were restructured to form only five main currencies: the US dollar, the German mark, the Japanese yen, the pound sterling and the French franc. CSDs have also been used as a unit currency for international transactions. But the dollar-based gold standard could not be maintained in the context of rising inflation and monetary expansion. In 1971, the Smithsonian Agreement, signed by the Group of Ten Major Countries, made changes to the gold exchange standard.

The price of gold was raised to $38 an ounce. Other countries have valued their currencies up to 10%. The exchange rate fluctuation band was increased from 1% to 2.25%. But the Smithsonian agreement proved ineffective and the Bretton Woods system collapsed. The Bretton Woods Agreement is one of those turning points in the development of modern financial systems that, after World War II, established the dollar as the standard currency for world trade. . . .