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International Trade and Finance

Notes There was to be a pool of member countries’ currencies, contributed on the basis of the quota system
fixed for the member countries, which would enable the Fund to act as a ‘lender of last resort’.
The Bretton Woods System never worked, the way its authors had intended. More specifically, the
threat to the Bretton Woods System arose out of two changes : (a) the expanded role of the US dollar
as international currency and a widely accepted asset, and (b) the exchange rate rigidity that developed
over time. Let us briefly explain these two problem spots.
At the end of World War II the United States held more than three-fourths of the world’s stock of
monetary gold, and accounted for half of the world’s GMP. For these reasons, the US dollar came to
be regarded as international money. Countries of the world began to hold their official reserves in the
form of US dollars. The US dollar was not only as good as gold, it was in fact better than gold because
dollar holding (as reserves) earned interest while gold did not. The US balance of payments deficits
after 1958 kept the entire world monetary system liquid. The steady accumulation of US dollars by
the foreign countries, especially of Europe, posed a threat to the stability of dollar as an international
reserve currency.
The second threat to the stability of the Bretton Woods System was the rigidity of exchange rates that
developed in reality. Notwithstanding some exchange rate adjustments during the early 1950s, the
world monetary system had, by 1960s, become a disequilibrium system characterized by persistent
deficits and surpluses. The Bretton Woods System failed to achieve equilibrium exchange rate stability.
The US dollar build up in the hands of the foreign central banks was the direct result of deep and
persistent US payments deficits. Even as early as 1964, the US dollar accumulations held by the
foreign countries equalled the total gold holdings of the United States. This excess accumulation of
US dollars in foreign countries led to unwillingness of the foreign central banks to hold US dollar as
currency reserves. The value of dollar began to depreciate, and the gold price began to shoot up after
1968. In March 1968, the United States and the European countries agreed to establish, at the US request,
the so-called Two-tier Gold Market. This measure separated the private gold market from the official
gold market in which the central banks bought and sold gold to each other. The price of gold in the
private market might rise above US $35 an ounce, but the central banks continued to deal in gold with
each other at the fixed price of US $35 an ounce. (Since the time the US enacted the Gold Reserve Act of
1934, the US government had undertaken to buy or sell unlimited quantities of gold at a fixed price of
US $35 an ounce). The European countries agreed not to press the United States to convert their US
dollar accumulations into gold. The US dollar became virtually inconvertible into gold in 1968.
25.1 Meaning of International Monetary System

International monetary system refers to the system prevailing in world foreign exchange markets
through which international trade and capital movements are financed and exchange rates are
determined. We discuss below the international monetary system since the end of the World War II.
25.2 The Bretton Woods System

The Bretton Woods System finally collapsed in 1971, and this was caused by the so-
called Dollar Crisis of 1971. The dollar crisis stemmed from the US balance of
payments deficits.

During the period preceding World War I almost all the major national currencies were on a system of
fixed exchange rates under the international gold standard. This system had to be abandoned during
World War I. There were fluctuating exchange rates from the end of the War to 1925. Efforts were made
to return to the gold standard from 1925. But it collapsed with the coming of the Great Depression.
Many countries resorted to protectionism and competitive devaluations—with the result that world
trade was reduced to almost half. But depression completely disappeared during World War II.

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