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1. Explain the Bretten wood System?

(Also called the IMF’s Fixed Exchange Rate System)
Representatives of 45 major economies met at Bretton Woods, USA, in July 1944
to finalize a new Exchange Rate System based on stability and flexibility to be
universally implemented after the Second World War. Deliberations during this
meeting resulted in the formation of two international multi – lateral institutions

1. International Monetary Fund (IMF)
2. International Bank for Reconstruction and Development (IBRD) – known as the
World Bank.

The IMF was given the mandate to establish a suitable exchange rate system. The
Fixed Exchange Rate System proposed by them was implemented in 1946. The
main features of this system were as follows:
1. In addition to gold, the US Dollar (USD) was to be given the status of universal
reserve asset. This means that in addition to gold reserves, countries could issue
domestic money against USD reserves. The value of USD was fixed at 1 ounce of
gold = USD 35.

2. The US Federal Reserve Bank (The American Central Bank) provided an
unconditional guarantee to buy and sell unlimited quantity of gold at this price.
This was called the Gold Convertibility Clause.

3. No other country was required to provide for redemption of its currency against

The extreme points of the variation zone were called ‘support points’ or ‘intervention points’. Variation in the exchange rate was permitted on either side of parity in a range of (+/-) 1% 8. USD and domestic currency was called the PAR VALUE MECHANISM. 4. The equality between gold.nor were they required to fix an official gold price. Each member country was required to fix a PARITY VALUE for its currency againstUSD. All currencies were pegged to USD at fixed parity rates therefore their cross relationships were also constant. The system introduced the concept of Central Bank intervention as a means of ensuring protection of parity rates (intervention means proactive participation of a Central Bank in the domestic markets with the intention of influencing exchange rate .) 5. 6. The USD therefore became the means of international settlements. 7. The actual rate or multiple is called PARITY. 9. Effectively every currency was redeemable in terms of USD and only USD was redeemable in terms of gold. Therefore this system was also called the ‘Gold Exchange Standard’. (The process of fixing the value for a currency as a multiple of another currency is called PEGGING. The USD functioned as the universal vehicle currency.

13. the system was also viewed as ‘The Adjustable Peg System’ 12. 2. The IMF provided a commitment to the member countries to provide assistance to countries facing temporary balance of payment deficits. As in the case of Gold Standard. The concept of ‘dual exchange rates’ was abolished. 2. In case of structural imbalances in the Balance of Payments. This aggravated the US trade deficit. member countries could devalue their currencies in consultation with the IMF. this system also did not provide for any revision in the price of gold.movement. . All member countries accepted the supervisory authority of the IMF in regards to the exchange rate management system and the domestic foreign exchange market. The system did not provide for any revaluation of parities due to which surplus countries such as West Germany and Japan continued to enjoy export competitiveness against the US economy. This led to the suspension of gold production in various countries leading to stagnation of gold reserves which had an adverse impact on international liquidity. what were the Reasons for the failure of bretten wood system ? ans 1. it became uneconomical to produce gold. On account of this flexibility. 11. Due to inflation.) 10. This was the first instance in history when all countries of the world voluntarily accepted to give up a part of their sovereignty (freedom to decide) in connection with their foreign exchange management systems.

3. The system did not provide for a revision in the price of gold in terms of USD. the US authorities could not honour their commitment to redeem USD against gold. What is Triffins Paradox? Ans The success of the Bretten Woods System was essentially based on the voluntary trade deficit accepted by the US. In 1968. Due to this. The American involvement in Vietnam resulted in uncontrolled deficit. The devaluation of the dollar would have adversely affected all countries having USD reserves.3. This step resulted in a net outflow of US Dollars to the world economy. This failure on the part of the US led to the collapse of the system in 1971. Professor Triffin. it was not possible to devalue the US Dollar despite continued trade deficit. The formal withdrawal from the system was . the Gold Convertibility Clause was invoked but the US Federal Reserve Bank could not honour its commitment. He predicted that the system would disintegrate due to this basic weakness in the system that it did not provide for a periodic review of the value of the USD. The continued trade deficit of the US created an over-supply of USD in the international financial markets which reduced the acceptability of the USD. When the Gold Convertibility Clause was invoked. predicted that the continuous deficit in balance of trade incurred by the US would reduce its acceptability in the international markets since supply would keep increasing without a downward revision in the value of USD. 4. an economist.

Under the gold standard. thus resulting in the collapse of the system as predicted by Professor Triffin. deficit in the balance of payments will give rise to an excess supply of the country’s currency and the exchange rate will. exchange rates are freely determined on open market primarily by private dealings. and they. tend to fall. pegged rate and to change their value only at fairly infrequent intervals. What is floating or flexible exchange rate? Ans Floating exchange rate refers to the exchange rate which is determined by the conditions of demand for and supply of the foreign exchange in the exchange market. each member country of the IMF defined the value of its currency in terms of gold or the US dollar and agreed to maintain (to peg) the market value of its currency within per cent of the defined (par) value. vary from day-to-day. Surplus in the balance of payments will create an excess demand for the country’s currency and the exchange rate will tend to rise. . the values of currencies were fixed in terms of gold. 1971. like other market prices. at a fixed. the breakdown of the Bretten Wood System. 5. What is Fixed rate exchange system? Ans Countries following the fixed exchange rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies.announced by the US on 15th August. some countries took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system. Under the flexible exchange rate system. the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. Following. On the other hand. 4. when the economic situation forces them to do so. hence. Until the breakdown of the Bretton Woods System in the early 1970. Under the flexible exchange rate system.

and transfers such as gifts. the examination of BOP is required. The balance of payments classifies these transactions in two accounts – the current account and the capital account. BOP is useful as a guide to the monetary. also known as balance of international payments. services and income. 7. investment income and current transfers. In order to increase the bank rate. What is LERMS? Ans An acronym for liberalization Exchange Management System that was introduced from March 1. trade and other policies. The objective was to encourage exporters and induce a greater inflow of remittances through proper channels as well as bring about greater efficiency in . The developments in the BOP are of special concern to those interested in formulation of correct national economic policies. while the capital account mainly includes transactions in financial instruments. BOP has emerged as a major branch of economics in recent years. services. The balance of payments. 6. 1992 under which the rupee was made partially convertible. The current account includes transactions in goods. What is Balance of Payments? Ans Balance of payment is a statement that summarizes an economy’s transactions with the rest of the world for a specified time period. encompasses all transactions between a country’s residents and its non-residents involving goods. The BOP also assists in assessing the country’s ability to pay for the current goods and services. The tax measure on export or imports may also affect the BOP. financial claims on and liabilities to the rest of the world. fiscal.

Importers could obtain their requirements of foreign exchange from authorized dealers at the market rate. This unification was recommended as an important step towards full convertibility by the committee on balance of payments under the chairmanship of C Ragranajan. Under the unified rate system all foreign exchange transactions through authorized dealers out at market determined rate exchange. this system was replaced by a unified exchange rate in March 1993. Because of certain weaknesses. . percent of eligible foreign exchange receipts such as exports earnings or remittances was to be converted at the market rate and the balance 40% at the official rate of exchange.import substitution. Under the system.