Bretton Woods Agreement

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The Bretton Woods Agreement of 1944 was made in Bretton Woods, New Hampshire, and helped to establish a fixed exchange rate in terms of gold for major currencies. The International Monetary Fund (IMF) was also established at this time. The system was devised by the economists Harry Dexter White and John Maynard Keynes. It fixed the dollar's value at $35 for an ounce of gold. Governments, rather than speculators, would set the value of their currencies in relation to the dollar and would have to disclose any changes in advance to the IMF.

For 25 years after WWII, the international monetary system known as the Bretton Woods system was based on stable and adjustable exchange rates. Exchange rates were not permanently fixed, but there were occasional devaluations of individual currencies to correct fundamental disequilibria in the British pound. Increasing pressures during the 1960s culminated in the collapse of the Bretton Woods system in 1971, when President Richard Nixon announced that the U.S. dollar would no longer be convertible to gold. The system was reluctantly replaced with a regime of floating exchange rates.

In the late 1990s and early 2000s, however, China and other countries fixed their exchange rate to the U.S. dollar, while funding the United States' current account deficit. That era is sometimes referred to as Bretton Woods II.

Three points:

1. By signing the agreement, nations were submitting their exchange rates to international disciplines. This amounted to a significant surrender of national sovereignty to an international organization.
2. A nation does not have to resort to the classical medicine of deflating the domestic economy when faced with chronic British pound deficits. Before World War II, European nations often resorted to this policy, in particular Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policy after WWI. Since deflationary policy is no longer a must, the adjustable peg was viewed as a vast improvement over the gold exchange standard with fixed parity. Currencies were convertible into gold, but unlike the gold exchange standard, countries had this ability to change par values. For this reason, Keynes described the Bretton Woods system as "the exact opposite of the gold standard."
3. The dollar was the numeraire of the system, i.e., it was the standard to which every other currency was pegged. Accordingly, the U.S. did not have the power to set the exchange rate between the dollar and any other currency. Changing the value of dollar in terms of gold has no real effect, because the values of other currencies were pegged to the dollar. This is the n-th currency problem. This problem would not have existed if most of other currencies were pegged to gold or other currencies. However, none of these currencies pegged to gold because they were not convertible to into gold.

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