The International Monetary

System and the Balance of

Payments P2
Session 17
 The IMF and the World Bank provided the institutional
framework for the post–World War II international monetary
system.

A Dollar- The Bretton Woods participants also addressed the problem of

how the system would function in practice.

Based Gold All countries agreed to peg the value of their currencies to gold.

Standard
For example, the par value of the U.S. dollar was established at
$35 per ounce of gold.

However, only the United States pledged to redeem its currency

for gold at the request of a foreign central bank. Thus, the U.S.
dollar became the keystone of the Bretton Woods system.
 • During the early postwar years, only the U.S.
A Dollar- and Canadian dollars were convertible
currencies, that is, ones that could be freely
Based Gold exchanged for other currencies without legal
restrictions. Countries had faith in the U.S.
Standard economy and so were willing to accept U.S.
dollars to settle their transaction.
 • Because each country established a par value for
its currency, the Bretton Woods Agreement
resulted in a fixed exchange rate system.
• Under the agreement each country pledged to
A Dollar- maintain the value of its currency within ±1
percent of its par value.
Based Gold
Standard • If the market value of its currency fell outside
that range, a country was obligated to intervene
in the foreign-exchange market to bring the value
back within ±1 percent of par value.
 • Accordingly, the Bretton Woods
system is often described as
using an adjustable peg because
currencies were pegged to gold,
but the pegs themselves could be
A Dollar-Based altered under certain conditions.
Gold Standard
 • Under the system, for example, the British pound’s
par value was first set at $2.80. (Technically, the par
value was pegged to an ounce of gold, which then
could be translated into dollars at a rate of
$35.00 per ounce. Most businesspeople ignored
this technicality, however, and focused on the
implicit par value of a currency in terms of the U.S.
dollar.) Thus, the Bank of England was obligated to
keep the pound’s value between $2.772 and $2.828
Adjustable Peg (±1 percent of $2.80). In the event that pessimism
about the British economy caused the pound’s
market price to fall to $2.76, the Bank of England
would be required to defend the value of the pound
by selling some of its gold or U.S. dollar holdings to
buy pounds. This move would increase the demand
for pounds, and the market price would return to
within the legal range—from $2.772 to $2.828.
The End of the Bretton
Woods System
 • This arrangement worked well as
long as pessimism about a
country’s economy was
temporary, but if a country
suffered from structural
Bretton Woods macroeconomic problems, major
Condition difficulties could arise.
 • British productivity decreased relative to
that of its major international competitors,
and the pound’s value weakened. The
Bank of England had to intervene
continually in the foreign currency market,
Bank of selling gold and foreign currencies to
support the pound.
England
Intervention • In so doing, however, the bank’s holdings
of official reserves, which were needed to
back up the country’s Bretton Woods
pledge, began to dwindle. International
currency traders began to fear the bank
would run out of reserves.
 • Fears mounted, international banks,
currency traders, and other market
participants became unwilling to hold
British pounds in their inventory of
foreign currencies. They began
dumping pounds on the market as
Bank Reserves soon as they received them. A vicious
are dwindling cycle developed: As the Bank of
England continued to drain its official
reserves to support the pound, the
fears of the currency-market
participants that the bank would run
out of reserves worsened
 • Banks never have enough cash
on hand to honor all their
liabilities. However, as long as
people trust that their bank will
give them their money if they
Run on the need it, no one worries. If people
Bank lose that trust and withdraw
more of their money than the
bank has on hand, the bank
could be in trouble
 • The United Kingdom faced this type of bank
run in November 1967. The Bank of England
could not counter the flood of pounds
dumped on the market by speculators and
was forced to devalue the pound by 14.3
A real life percent (from $2.80 to $2.40 per pound).
France faced a similar run in 1969 and had to
Bank Run devalue the franc. These devaluations tested
the international business community’s faith
in the Bretton Woods system. But the system
faced its true Waterloo when the dollar came
under attack in the early 1970s.
 • The reliance of the Bretton Woods system on the
dollar ultimately led to the system’s undoing.
What causes Because the supply of gold did not expand in the
short run, the only source of the liquidity needed
Bretton to expand international trade was the U.S. dollar.
Under the Bretton Woods system, the expansion
Woods of international liquidity depended on foreigners’
willingness to continually increase their holdings
System to of dollars. Foreigners were perfectly happy to
hold dollars as long as they trusted the integrity

die? of the U.S. currency, and during the 1950s and

1960s the number of dollars held by foreigners
rose steadily
 • As foreign dollar holdings
increased, however, people began
to question the ability of the
United States to live up to its
Triffin Bretton Woods obligation. This led
Paradox to the Triffin paradox.
 • Named after the Belgian-born Yale University economist Robert
Triffin, who first identified the problem.
• The paradox arose because foreigners needed to increase their
holdings of dollars to finance expansion of international trade, but

What is
the more dollars they owned, the less faith they had in the ability
of the United States to redeem those dollars for gold.
• The less faith foreigners had in the United States, the more they

Triffin wanted to rid themselves of dollars and get gold in return. If they
did this, however, international trade and the international
monetary system might collapse because the United States did
Paradox? not have enough gold to redeem all the dollars held by foreigners.
 • As a means of injecting more liquidity
into the international monetary
system while reducing the demands
placed on the dollar as a reserve
currency, IMF members agreed in
SDRs 1967 to create special drawing rights
(SDRs). IMF members can use SDRs to
settle official transactions at the IMF.
Thus, SDRs are sometimes called
“paper gold.”
 • Although SDRs did provide new
liquidity for the international
monetary system, they did not
reduce the fundamental problem of
the glut of dollars held by
Dollar foreigners. By mid-1971, the
Bretton Woods system was
Instability tottering, the victim of fears about
the dollar’s instability. During the
first seven months of 1971, the
United States was forced to sell
one-third of its gold reserves to
maintain the dollar’s value.
 • It became clear to the marketplace
that the United States did not have
sufficient gold on hand to meet the
demands of those who still wanted
Bretton to exchange their dollars for gold. In
Woods a dramatic address on August 15,
1971, President Richard M. Nixon
System announced that the United States
would no longer redeem gold at
Ending $35 per ounce. The Bretton Woods
system was ended. In effect, the
bank was closing its doors
 • After Nixon’s speech most
currencies began to float, their
values being determined by
Effect of supply and demand in the
foreign-exchange market. The
President value of the U.S. dollar fell
relative to most of the world’s
Nixon’s major currencies. The nations of
speech the world, however, were not yet
ready to abandon the fixed
exchange rate system.
 • At the Smithsonian Conference, held in
Washington, D.C., in December 1971, central
bank representatives from the Group of Ten
agreed to restore the fixed exchange rate
system but with restructured rates of
exchange between the major trading
currencies. The U.S. dollar was devalued to
Smithsonian $38 per ounce but remained inconvertible into
gold, and the par values of strong currencies
Conference such as the yen were revalued upward.
Currencies were allowed to fluctuate around
their new par values by ±2.25 percent, which
replaced the narrower ±1.00 percent range
authorized by the Bretton Woods Agreement