Bretton Woods and the Adjustable-Peg System

The leaders of the allied nations met at Bretton Woods, New Hampshire in 1944, to set up a better system of fixed exchange rates. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars. This official fixed rate of exchange was known as the par value of currency (aka par of exchange, par exchange rate).

However, to avoid making deleterious macroeconomic adjustments to maintain the exchange rate, the new system provided for an adjustable peg, that allowed the exchange rate to be altered under specific circumstances. Thus, this Bretton Woods system was also known as the adjustable-peg system. To actuate this new system, the International Monetary Fund (IMF) was created.

Each country had to maintain an account at the IMF that was proportional to the country's population, volume of trade, and national income. One of the services provided by the IMF was to provide accounts for each of the participating countries that held Special Drawing Rights (SDR), which were units of account that could be used to settle IMF transactions through the transference of the SDRs. Although initially the SDR was pegged to gold, it is currently equalized to the weighted average of the currencies of the 5 largest IMF exporters.

The new system required that each country value its currency in terms of gold or the United States dollar, which, of course, fixed the exchange rate among all currencies. The countries were required to maintain the exchange rate to within 1% of the peg, but, if special circumstances required, they could allow the exchange rate to fluctuate by up to 10%. However, if this was not adequate, then the country would have to seek approval from the IMF board to change the exchange rate by more than 10%. This prevented countries from devaluing their currency for their own benefit.

To maintain the limits, a country could:

    use official reserves, which is the foreign currency held by a country from a previous surplus.
    borrow from the IMF by borrowing the foreign currency, and using its own currency as collateral.
    sell gold to a country for its currency.

The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amounts of U.S. dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the U.S. had enough gold to redeem all the dollars.

With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold, so the exchange rate was allowed to float. Because of the central role played by the United States, the Bretton Woods system could not be sustained. By 1973, this action led to the system of managed floating exchange rates that exists today.

Tags: exchange rates macroeconomic adjustments exchange rate income transference special drawing rights (sdr)