The Global Monetary System Under The Dollar Standard

The Great Depression had also led to broad-based protectionism and, under the leadership of Germany, to a myriad of bilateral trade agreements that ended up destroying multilateralism in trade and payments. Bretton Woods worked remarkably well for the first few decades of its existence, and global finance responded positively to the corollary exchange rate stability and reduced risk in international investment. In the end, however, it was global finance itself – reacting to the fundamental weakening of the US commitment to dollar–gold parity over time – which helped to place the system under stress. By 1971, the inconsistency between an expanding supply of US dollars and a commitment to dollar–gold parity led some countries to demand conversion of their dollars into gold. The weight of that conversion burden on the United States was too great to uphold, and the system of fixed exchange rates relative to the dollar came to an end.

The additional funds were to be used for mortgages and state and local government bonds, thus putting downward pressure on long-term rates. By working in both the spot and forward markets, the Treasury in creased the cost of exchange risk on dollars to speculators and traders, thus reducing their incentives to sell dollars for foreign currencies. The Ottoman government adhered to this framework, with some exceptions, until the nineteenth century. While the practices of medieval and early modern states in Europe and the Near East varied in time and space, the majority pursued a flexible approach similar to those of the Ottomans.

Other countries devalued their currencies in retaliation of the lower US dollar. Many of these countries used arbitrary par values rather than a price relative to their gold reserves. Each country hoped to make its exports cheaper to other countries and reduce expensive imports.

Member countries had to maintain the value of their currencies within 1 percent of the fixed exchange rate. Lastly, the agreement established that only governments, rather than anyone who demanded it, could convert their US dollar holdings into gold—a major improvement over the gold standard. In fact, most businesspeople eventually ignored the technicality of pegging the US dollar to gold and simply utilized the actual exchange rates between countries (e.g., the pound to the dollar) as an economic measure for doing business. The international monetary system consists of exchange rate arrangements; capital flows; and a collection of institutions, rules, and conventions that govern its operation.

These pegs were intended to be adjustable if “fundamental disequilibria” occurred, and were accompanied by tight capital controls that were designed to prevent speculative attacks and afford central banks a modicum of policy independence. In the event that any balance of payments problems arose, the IMF stood ready to extend credits to the affected nation. In sum, the system was intended to marry flexibility and stability, overcoming the inadequacies of the Classical Gold Standard. Some drawbacks of fixed exchange rates include the fear of devaluation, where a central bank may use its reserves to maintain the foreign exchange rate, and when reserves are exhausted that compels the government to devalue its domestic currency.

The key to the success of managed floating is the credible adherence by central banks to a credible low inflation target. With the collapse of fixed exchange rates in 1973, the dominant role of the IMF was to provide financial support for member countries. Its involvement is virtually required before international bankers will agree to refinance or defer loans for Third World countries. The IMF was also instrumental in providing funds for the emerging market economies in eastern Europe following the breakup of the Soviet Union in 1991.

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