The Bretton Woods agreement of 1944 established a new international monetary system. It replaced thegold standard with theU.S. dollaras theglobal currency. By so doing, it established America as the dominant power in theworld economy. After the agreement was signed, America was the only country with the ability toprint dollars.
The agreement created theWorld Bankand theInternational Monetary Fund (IMF), U.S.-backed organizations that would monitor the new system.
Key Takeaways
- The creation of Bretton Woods resulted in countries pegging their currencies to the U.S. dollar.
- In turn, the dollar was pegged to the price of gold, and the U.S. became dominant in the world economy.
- The U.S. was the only nation that could print the globally accepted currency, and countries had more flexibility than they did with the old gold standard.
- When the dollar ceased to be pegged to the price of gold, it became the monetary standard with other currencies pegging their currencies to it.
The Bretton Woods Agreement
The Bretton Woods agreement was created in a 1944 conference of all of the World War II Allied nations. It took place in Bretton Woods, New Hampshire.
Under the agreement, countries promised that theircentral bankswould maintainfixed exchange ratesbetween their currencies and the dollar. If a country's currency value became too weak relative to the dollar, the bank would buy up its currency inforeign exchange markets.
Note
Purchasing currency would lower the supply of the currency and raise its price. If acurrency's price became too high, the central bank would print more. This printing production would increase the supply and lower the currency's price.
Members of the Bretton Woods system agreed to avoid trade wars. For example, they wouldn't lower their currencies strictly to increase trade. But they could regulate their currencies under certain conditions. For example, they could take action ifforeign direct investmentbegan to destabilize their economies. They could also adjust their currency values to rebuild after a war.
Replacing the Gold Standard
Before Bretton Woods, most countries followed thegold standard. That meant each country guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold.
Why dollars? The United States held three-fourths of the world's supply of gold. No other currency had enough gold to back it as a replacement. The dollar's value was 1/35 of an ounce of gold. Bretton Woods allowed the world to slowly transition from a gold standard to a U.S. dollar standard.
Note
Over time, the dollar became a substitute for gold. As a result, thevalue of the dollarbegan to increase relative to other currencies.
The transition created moredemandfor dollars, even though its worth in gold remained the same. This discrepancy in value planted the seed for the collapse of the Bretton Woods system three decades later.
Why the Agreement Was Needed
Until World War I, most countries were on the gold standard. However, they cut the tie to gold so they could print the currency needed to pay for their war costs. This inflow of currency causedhyperinflation, as thesupply of moneyoverwhelmed the demand. After the war, countries returned to thesafety of the gold standard.
Note
Hyperinflation caused thevalue of moneyto fall so dramatically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread.
All went well until theGreat Depression. After the1929 stock market crash, investors switched tocommodities trading. It drove up theprice of gold, resulting in people redeeming their dollars for gold. TheFederal Reservemade things worse by defending the nation's gold reserve by raisinginterest rates.
The Bretton Woods system gave nations more flexibility than strict adherence to the gold standard. It also provided lessvolatilitythan a currency system with no standard at all. A member country still retained the ability to alter its currency's value, if needed, to correct a "fundamental disequilibrium" in itscurrent account balance, the Federal Reserve noted.
Role of the IMF and World Bank
The Bretton Woods system could not have worked without the IMF. Member countries needed it to bail them out if their currency values got too low. They'd need a kind of global central bank they could borrow from if they needed to adjust their currency's value and didn't have the funds themselves. Otherwise, they would just slap on trade barriers or raise interest rates.
The Bretton Woods countries decided against giving the IMF the power of a global central bank. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be held by the IMF. Each member country of the Bretton Woods system was then entitled to borrow what it needed, within the limits of its contributions. The IMF was also responsible for enforcing the Bretton Woods agreement.
Note
The IMF was not designed to print money and influence economies with monetary policies.
The World Bank, despite its name, was not the world's central bank. At the time of the Bretton Woods agreement, the World Bank was set up to lend to the European countries devastated by World War II. The purpose of the World Bank changed to loaning money to economic development projects in emerging market countries.
The Collapse of the Bretton Woods System
In 1971, the United States suffered from massivestagflation—a combination ofinflation and recession, which causes unemployment and low economic growth.
In response to a dangerous dip in value caused by too much currency in circulation,President Nixonstarted to deflate the dollar's value in gold. Nixon devalued the dollar to 1/38 of an ounce of gold, and then to 1/42 of an ounce.
The devaluation plan backfired. It created a run on the U.S. gold reserves atFort Knoxas people redeemed their quickly devaluing dollars for gold. In 1971, Nixon unhooked the value of the dollar from gold altogether. Without price controls, gold quickly shot up to $120 per ounce in thefree market, ending the Bretton Woods system.
Frequently Asked Questions (FAQs)
What was the Bretton Woods Agreement?
The Bretton Woods Agreement was a 1944 meeting of the Allied nations, in which the nations agreed to peg their currencies to the dollar while the dollar was pegged to gold. The agreement went into effect in 1958 but lasted less than 20 years.
What is the gold standard?
The gold standard was a currency measurement system in place in the United States up until the 1970s in which the value of the dollar was tied to gold. At the time of the Bretton Woods Agreement, one dollar was worth 1/35 of an ounce of gold.
