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Unit 25 : International Monetary System

In July 1944, the allied countries met at Bretton Woods in the USA to avoid the rigidity of the gold Notes
standard and the chaos of the 1930s in international trade and finance and to encourage free trade.
The new system was the present International Monetary Fund (IMF) which worked out an adjustable
peg system.
Under the Bretton Woods system exchange rates between countries were set or pegged in terms of
gold or the US dollar at $ 35 per ounce of gold. This related to a fixed exchange rate regime with
changes in the exchange within a band or range from 1 per cent above to 1 per cent below the par
value. But these adjustments were not available to US which had to maintain the gold value of dollar.
If the exchange rate hit either of the bands, the monetary authorities were obliged to buy or sell
dollars against their currencies. Large adjustments could be made where there were “fundamental
disequilibrium” (i.e. persistent and large deficits or surpluses) in BOP with the approval of the IMF
and other countries. Member countries were forbidden to impose restrictions on payments and trade,
except for a transitional period. They were allowed to hold foreign reserves partly in gold and partly
in dollars. These reserves were meant to incur temporary deficits or surpluses by member countries,
while keeping their exchange rates stable. In case of a BOP deficit, there was a reserve outflow by
selling dollar and reserve inflow in case of a BOP surplus.
Reserve outflows were a matter of concern under the Bretton Woods system. So the IMF insisted on
expenditure reducing policies and devaluation to correct BOP deficit. Temporary BOP deficits were also
met by borrowing from the Fund for a period of 3 to 5 years. A country could borrow from the Fund on
the basis of the size of its quota with it. The loans made by the IMF were in convertible currencies.
The first 25 per cent of its quota was in gold tranche which was automatic and the remaining under the
credit tranches which carried high interest rates. To provide long-term loans the World Bank (or IBRD)
was set in 1946 and subsequently its two affiliates, the International Finance Corporation (IFC) in
1956 and International Development Association (IDA), in 1960. For the removal of trade restrictions,
the General Agreement on Tariffs and Trade (GATT) came into force from January 1948. To supplement
its resources, the and started borrowing from the ten industrialised countries in order to meet the
requirements of the International monetary system under General Agreements to Borrow (GAB)
from October 1962. Further, it created Special Drawing Rights (SDRs) is January 1970 to supplement
international reserves to meet the liquidity requirements of its members. The Bretton Woods system
worked smoothly from 1950s to mid 1960s. During this period world output increased and with the
reduction of tariffs under the GATT, world trade also use.
The Breakdown of the Bretton Woods System
The following are the principal causes and sequences of the breakdown of the Bretton Woods system.
1. Built-in Instability : The Bretton Woods System had a built-in instability that ultimately led to
its breakdown. It was an adjustable peg system within plus or minus 1 per cent of the par value
of $35. In case of fundamental disequilibrium, a country could devalue its currency with the
approval of the IMF. But countries were reluctant to devalue their currencies because they had
to export more goods in order to pay for dearer imports from other countries. This led countries
to rely on deflation in order to cure BOP deficits through expenditure-reducing monetary-fiscal
policies. The UK often restored to deflation such as in 1949, 1957 and 1967.
2. The Triffin Dilemma : Since the dollar acted as a medium of exchange, a unit of account and a
store of value of the IMF system, every country wanted to increase its reserves of dollar which
led to dollar holdings to a greater extent than needed. Consequently, the US gold stock continued
to decline and the US balance of payments continued to deteriorate. Robert Triffin warned in
1960 that the demand for world liquidity was growing faster than the supply because the
incremental supply of gold was increasing little. Since the dollar was convertible into gold, the
supply of US dollars would be inadequate in relation to the liquidity needs of countries. This
would force the US to abandon its commitment to convert dollars into gold. This is the Triffin
Dilemma which actually led to the collapse of the Bretton Woods System in August 1971.
3. Lack of International Liquidity : There was a growing lack of international liquidity due to
increasing demand for the dollar in world monetary markets. With the expansion of world

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