BRETTON WOODS SYSTEM:

Bretton Woods is the name of the town in the state of New Hampshire, USA, where the
delegations from over forty five countries met in 1944 to deliberate on proposals for a post-war
international monetary system. The two main contending proposals were “the White plan”
named after Harry Dexter White of the US Treasury and the “Keynes plan” whose architect was
Lord Keynes of the UK. Following the Second World War, policy makers from victorious allied
powers, principally the US and UK, took up the task of thoroughly revamping the world
monetary system for the non-communist world. The outcome was the so called “Bretton Woods
System” and the birth of new supra-national institutions, the International Monetary Fund (the
IMF or simply the “Fund”) and the World Bank.

Under this system US Dollar was the only currency that was fully convertible to gold; where
other countries currencies were not directly convertible to gold. Countries held US dollars, as
well as gold,  for use as an international means of payment.

The system proposed an international clearing union that would create an international reserve
asset called “bancor”. Countries would accept payment in bancor to settle international
transactions without limit. They would also be allowed to acquire bancor by using overdraft
facilities with the clearing union. In return for undertaking this obligation, the member countries
were entitled to have access to credit facilities from the IMF to carry out their intervention in the
currency markets.

The novel feature of regime which makes it an adjustable peg system rather than a fixed rate
system like the gold standard was that the parity of a currency against the dollar could be
changed in the face of a fundamental equilibrium. A fundamental equilibrium is said to exist
when at the given exchange rate, the country repeatedly faces balance of payment disequilibria,
and has to constantly intervene and sell foreign exchange (persistent deficits) or buy foreign
exchange (persistent surpluses) against its own currency. The situation of persistent deficits is
much more difficult to deal with and calls for a devaluation of the home currency. Changes of

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upto 10% in either direction could be made without the consent of the Fund and obtaining their
approval.

Under the Bretton Wood System, the US dollar in effect became international money. Other
countries accumulated and held dollar balances with which they could settle their international
payments; the US could in principal buy goods and services from other countries simply by
paying with its own money. This system could work as long as other countries had confidence in
the stability of the US dollar and in the ability of the US treasury to convert dollars into gold on
demand at the specified conversion rate.

Professor Robert Triffin warned that gold exchange system was programmed to collapse in the
long run.  To satisfy the growing needs of reserves, the US had to run BOP deficits continuously
which would eventually impair the public confidence in the dollar, triggering a run on the dollar. 
If reserve currency country runs BOP deficits to supply reserves, they can lead to a crisis of
confidence in the reserve currency itself causing the down fall of the system. This dilemma is
known as Triffin Paradox.

The system came under pressure and ultimately broke down when this confidence was shaken
due to various political and some economic factors starting in mid-1960s. On August 15, 1971,
the US government abandoned its commitment to convert dollars into gold at the fixed price of
$35 per ounce and the major currencies went on a float. An attempt was made to resurrect the
system by increasing the price of gold and widening the bands of permissible variation around
the central parity. This was the so called Smithsonian Agreement. That too failed to hold the
system together, and by early 1973, the world moved to a system of floating rates.

After a period of wild fluctuation in exchange rates – accentuated by real shock such as the oil
price crises in 1973 – policy makers in various countries started experimenting with exchange
rate regimes which were hybrids between fixed and floating rates. A group of countries in
Europe entered into Bretton Woods like engagement of adjustable pegs within themselves. This
was the European monetary system. Other countries tried various mixed versions.

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The Bretton Woods system of monetary management established the rules for commercial
and financial relations among the world's major industrial states in the mid 20th century. The
Bretton Woods system was the first example of a fully negotiated monetary order intended to
govern monetary relations among independent nation-states.

Preparing to rebuild the international economic system as World War II was still raging, 730
delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods,
New Hampshire, United States, for the United Nations Monetary and Financial Conference. The
delegates deliberated upon and signed the Bretton Woods Agreements during the first three
weeks of July 1944.

Setting up a system of rules, institutions, and procedures to regulate the international monetary
system, the planners at Bretton Woods established the International Monetary Fund (IMF) and
the International Bank for Reconstruction and Development (IBRD), which today is part of
the World Bank Group. These organizations became operational in 1945 after a sufficient
number of countries had ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt
a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and
the ability of the IMF to bridge temporary imbalances of payments.

On August 15, 1971, the United States unilaterally terminated convertibility of the dollar to gold.
As a result, "[t]he Bretton Woods system officially ended and the dollar became fully 'fiat
currency,' backed by nothing but the promise of the federal government. This action, referred to
as the Nixon shock, created the situation in which the United States dollar became the sole
backing of currencies and a reserve currency for the member states.

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 FEATURES OF THE BRETTON WOODS INTERNATIONAL DOLLAR STANDARD:

1. First, it was a US dollar-based system. Officially, the Bretton Woods system was a gold-
based system which treated all countries symmetrically, and the IMF was charged with the
responsibility to manage this system. In reality, however, it was a US-dominated system with
the US dollar playing the role of the key currency (the dollar’s dominance still continues today).
The relationship between the US and other countries was highly asymmetric. The US, as the
center country, provided domestic price stability which other countries could “import,” but did
not itself engage in currency intervention (this is called benign neglect; i.e., the US did not care
about exchange rates, which was desirable). By contrast, all other countries had the obligation to
intervene in the currency market to fix their exchange rates against the US dollar.

2. Second, it was an adjustable peg system. This means that exchange rates were normally
fixed but permitted to be adjusted infrequently under certain conditions. As a consequence,
exchange rates were supposed to move in a stepwise fashion. This was an arrangement to
combine exchange rate stability and flexibility, while avoiding mutually destructive devaluation.
Member countries were allowed to adjust “parities” (exchange rates) when “fundamental
disequilibrium” existed. However,  “fundamental disequilibrium” was not clearly defined
anywhere. In reality, exchange rate adjustments were implemented far less often than the
builders of the Bretton Woods system imagined. Germany revalued twice, the UK devalued
once, and France devalued twice. Japan and Italy did not revise their parities.

3. Third, capital control was tight. This was a big difference from the Classical Gold
Standard of 1879-1914, when there was free capital mobility. Although the US and Germany
had relatively less capital-account regulations, other countries imposed severe exchange
controls.

4. Fourth, macroeconomic performance was good. In particular, global price stability and
high growth were simultaneously achieved under deepening trade liberalization. In particular,
stability in tradable prices (wholesale prices or WPI) from the mid 1950s to the late 1960s was

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almost perfect and globally common. This macroeconomic achievement was historically
unprecedented.

EXCHANGE RATE:

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate)
between two currencies specify how much one currency is worth in terms of the other. It is the
value of a foreign nation’s currency in terms of the home nation’s currency. For example an
exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY
91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the
world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to
an exchange rate that is quoted and traded today but for delivery and payment on a specific
future date.

Quotations:

An exchange system quotation is given by stating the number of units of "quote currency" (price
currency, payment currency) that can be exchanged for one unit of "base currency" (unit
currency, transaction currency). For example, in a quotation that says the EUR/USD exchange
rate is 1.2290 (1.2290 USD per EUR, also known as EUR/USD; see foreign exchange market),
the quote currency is USD and the base currency is EUR.

There is a market convention that determines which is the base currency and which is the term
currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others.
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the
term currency and the exchange rate tells you how many Australian dollars you would pay or
receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and others were
recently removed from this list when they joined the euro. In some areas of Europe and in the
non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base
currency to the euro. In order to determine which is the base currency where both currencies are

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not listed market convention is to use the base currency which gives an exchange rate greater
than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal
places.

Free or pegged:

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies
and is determined by the market forces of supply and demand. Exchange rates for such
currencies are likely to change almost constantly as quoted on financial markets, mainly by
banks, around the world. A movable or adjustable peg system is a system of fixed exchange
rates, but with a provision for the devaluation of a currency. For example, between 1994 and
2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768
to $1. China was not the only country to do this; from the end of World War II until 1967,
Western European countries all maintained fixed exchange rates with the US dollar based on the
Bretton Woods system.

The "real exchange rate" (RER) is the purchasing power of two currencies relative to one
another. It is based on the GDP deflator measurement of the price level in the domestic and
foreign countries (P,Pf), which is arbitrarily set equal to 1 in a given base year. Therefore, the
level of the RER is arbitrarily set depending on which year is chosen as the base year for the
GDP deflator of two countries. The changes of the RER are instead informative on the evolution
over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of
the domestic country. If all goods were freely tradable, and foreign and domestic residents
purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP
deflators of the two countries, and the RER would be constant and equal to one.

Bilateral vs. effective exchange rate:

Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted
average of a basket of foreign currencies, and it can be viewed as an overall measure of the
country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with
the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts

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NEER by appropriate foreign price level and deflates by the home country price level. Compared
to NEER, a GDP weighted effective exchange rate might be more appropriate considering the
global investment phenomenon.

Uncovered interest rate parity:

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency
against another currency might be neutralized by a change in the interest rate differential. If US
interest rates increase while Japanese interest rates remain unchanged then the US dollar should
depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite,
appreciation, quite frequently happens, as explained below). The future exchange rate is reflected
into the forward exchange rate stated today. In our example, the forward exchange rate of the
dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it
does in the spot rate. The yen is said to be at a premium.

UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high
interest rates characteristically appreciated rather than depreciated on the reward of the
containment of inflation and a higher-yielding currency.

Balance of payments model:

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which
produces a stable current account balance. A nation with a trade deficit will experience reduction
in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency.
The cheaper currency renders the nation's goods (exports) more affordable in the global market
place while making imports more expensive. After an intermediate period, imports are forced
down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on trade-able goods and services,
ignoring the increasing role of global capital flows. In other words, money is not only chasing
goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows
go into the capital account item of the balance of payments, thus balancing the deficit in the
current account. The increase in capital flows has given rise to the asset market model.

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Asset market model:

The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts
and traders look at currencies. Economic variables such as economic growth, inflation and
productivity are no longer the only drivers of currency movements. The proportion of foreign
exchange transactions stemming from cross border-trading of financial assets has dwarfed the
extent of currency transactions generated from trading in goods and services.

The asset market approach views currencies as asset prices traded in an efficient financial
market. Consequently, currencies are increasingly demonstrating a strong correlation with other
markets, particularly equities.

Like the stock exchange, money can be made or lost on the foreign exchange market by investors
and speculators buying and selling at the right times. Currencies can be traded at spot and foreign
exchange options markets. The spot market represents current exchange rates, whereas options
are derivatives of exchange rates

Fluctuations in exchange rates:

A market based exchange rate will change whenever the values of either of the two component
currencies change. A currency will tend to become more valuable whenever demand for it is
greater than the available supply. It will become less valuable whenever demand is less than
available supply (this does not mean people no longer want money, it just means they prefer
holding their wealth in some other form, possibly another currency).

Increased demand for a currency is due to either an increased transaction demand for money or
an increased speculative demand for money. The transaction demand for money is highly
correlated to the country's level of business activity, gross domestic product (GDP), and
employment levels. The more people there are unemployed, the less the public as a whole will

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spend on goods and services. Central banks typically have little difficulty adjusting the available
money supply to accommodate changes in the demand for money due to business transactions.

Manipulation of exchange rates:

Countries may gain an advantage in international trade if they manipulate the value of their
currency by artificially keeping its value low. It is argued that the People's Republic of China has
succeeded in doing this over a long period of time. However, in a real-world situation, a 2005
appreciation of the Yuan by 22% was followed by a 38.7% increase in Chinese imports to the
US.

In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the
hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate
lowers the price of a country's goods for consumers in other countries but raises the price of
goods, especially imported goods, for consumers in the manipulating country.