Describe the basic principles of a Gold Standard system of exchange rates. To what extent did the Bretton-Wood system of exchange rates improve on the original Gold Standard?

iii) Reserves of gold: - The Central Bank should hold reserve of gold in direct proportion to the money note it issue, so that if anyone wants to turn there money into gold, there are always enough reserve to meet the demand of gold.

A lot of countries came off the gold standard during the first world war (1914). They returned after the war at pre -war exchange rates, while inflation had varied massively across different countries. This mean that there was significant variation in countries equilibrium exchange rate, so that some countries good were overpriced and some under priced. Inevitably, large balance of payment surplus' and deficits appeared. The system was too slow to make any the necessary adjustment to exchange rates and by the time of the great depression equilibrium had still not been attained. The onset of the depression destroyed the gold standard, with countries leaving the system by competitively devaluing their currencies, in order to get a competitive exchange rate advantage over others. Britain finally left the gold standard in 1931.

Having seeing the disaster of gold standard, a group of the major allied countries decided to establish a new international exchange standard to promote and facilitates a free flow of international trade.

The Bretton-Wood system was step up in 1947, New Hampshire to prevent recurring problems: -

a) Restrictive trade and exchange policies that followed after WWII,

b) Worldwide economics depression of the 1930s,

c) Virulent forms of economic nationalism and

d) Consequent outbreak of WWII.

Together with this, it was thought, at this time,

-To promote international cooperation on monetary problems;

-To counter volatility and reduce restriction on world trade and capital movement; along with IMF and World Bank. At the Bretton Woods international conference in 1944, the International Monetary Fund (IMF) and The World Bank was created with the task of maintaining stable economy by encouraging international monetary cooperation, currency convertibility, international liquidity, elimination of exchange restrictions; all of which are vital to the expansion of foreign trade and investment. Initially, the IMF required that every currency had a fixed exchange rate to the dollar, with the dollar fixed in terms of gold at $35.00 an ounce1. That is, a British trader could obtain U.S dollar (at a price of U.S $ 2.80 per pound), which could then be traded with the U.S. In practice, the Bretton Woods system became a dollar system because the USA emerged as the leading economy and the world's only creditor nation. On the other hand The World bank was established to encourage foreign investment directly by providing guarantees to private investors, participating in private loans, or investing it's own capital if none were available privately. The organisation was originally designed to provide capital to those countries rebuilding after war.

The Bretton Woods system was, fundamentally. A fixed exchange rate system but with a degree of flexibility in the case of fundamental balance of payment deficits or surpluses. Exchange rates were allowed to fluctuate by 1% initially, and later on by 2.25%, around their determined rate. This allowance for some adjustment of exchange system is called an adjustable peg system.

There were several major problems with the Bretton Woods system, which, eventually, led to collapse. The first of these was the reliance on the US Federal Reserve to sell gold at 35$ per OZ. Although the U.S had by foe large reserves of gold in the world in 1944, it did not have an infinite amount. This led to severe problems in the 1960's and 1970's. During 60's, the world supply of monetary gold grew at less than 2% while trade grew at nearly 10%. Gold, which had been 66% of the total monetary reserves in 1959, was only30% by 1972.2 By the late 60's the US had lost so much gold that confidence was becoming undermined as to it's ability to maintain convertibility. The second problem was that in 1968, central bank stopped trading gold with individuals (they would only exchange gold for currency with other central banks). Which in effect created a two-tiered gold market with an official price at the central banks and a market price determined by the interaction of private demand and supply.

The Bretton Wood system functioned adequately until the late 1960's when both the dollar and the pound started to experience fierce speculative attacks. These led to the devaluation of the pound in 1967 (from$2.80 to $2.40 per oz 1) and, in turn, set off a series of devaluation's of other currencies. These events sparked off increasing flows of capital out of dollars and into other currencies, notably the yen and the deutschmark.

The Bretton Woods agreement has several lasting legacies still important today. The most important institution of these is the International Monetary Fund. This organisation was created by the Bretton Wood agreement to be the banker and supervisor of the whole system and has survived today as a kind of global bank available to supply finance to individual governments.

Bibliography

) Plibeam, K. (1998), International Finance, Macmillan.

2) www.bankofengland.com

3) www.binghamton.edu/igcs_site/Bretton%Woods.html.

4) Lectures notes.

Appendix 1

Appendix 2

Appendix 3

IMF, Articles of agreement.

2 Lipsey+Chrystal, 1995, Chap 37.