Financial Markets and Institutions (2-downloads)

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Fixed Exchange Rate Regimes

After World War II, the victors set up a fixed exchange rate system that became known

as the Bretton Woods system, after the New Hampshire town in which the agree-

ment was negotiated in 1944. The Bretton Woods system remained in effect until 1971.

The Bretton Woods agreement created the International Monetary Fund

(IMF), headquartered in Washington, D.C., which had 30 original member countries

in 1945 and currently has over 180. The IMF was given the task of promoting the growth

of world trade by setting rules for the maintenance of fixed exchange rates and by mak-

ing loans to countries that were experiencing balance-of-payments difficulties. As

part of its role of monitoring the compliance of member countries with its rules, the

IMF also took on the job of collecting and standardizing international economic data.

The Bretton Woods agreement also set up the International Bank for Reconstruction

and Development, commonly referred to as the World Bank. Headquartered in

Washington, D.C., it provides long-term loans to help developing countries build dams,

roads, and other physical capital that would contribute to their economic develop-

ment. The funds for these loans are obtained primarily by issuing World Bank bonds,

which are sold in the capital markets of the developed countries. In addition, the General

Agreement on Tariffs and Trade (GATT), headquartered in Geneva, Switzerland, was

set up to monitor rules for the conduct of trade between countries (tariffs and quo-

tas). The GATT has since evolved into the World Trade Organization (WTO).

Because the United States emerged from World War II as the world’s largest

economic power, with over half of the world’s manufacturing capacity and the greater

part of the world’s gold, the Bretton Woods system of fixed exchange rates was based

on the convertibility of U.S. dollars into gold (for foreign governments and central

banks only) at $35 per ounce. The fixed exchange rates were to be maintained by

intervention in the foreign exchange market by central banks in countries besides the

United States that bought and sold dollar assets, which they held as international

reserves. The U.S. dollar, which was used by other countries to denominate the assets

that they held as international reserves, was called the reserve currency. Thus,

an important feature of the Bretton Woods system was the establishment of the

United States as the reserve currency country. Even after the breakup of the Bretton

Woods system, the U.S. dollar has kept its position as the reserve currency in which

most international financial transactions are conducted. However, with the creation

of the euro in 1999, the supremacy of the U.S. dollar may be subject to a serious chal-

lenge (see the Global box, “The Euro’s Challenge to the Dollar”).

The fixed exchange rate, which was a feature of the Bretton Woods system was

finally abandoned in 1973. From 1979 to 1990, however, the European Union insti-

tuted among its members its own fixed exchange rate system, the European Monetary

System (EMS). In the exchange rate mechanism (ERM) in this system, the

exchange rate between any pair of currencies of the participating countries was not

supposed to fluctuate outside narrow limits, called the “snake.” In practice, all of

the countries in the EMS pegged their currencies to the German mark.

How a Fixed Exchange Rate Regime Works

Figure 16.2 shows how a fixed exchange rate regime works in practice by using the

supply-and-demand analysis of the foreign exchange market we learned in the pre-

vious chapter. Panel (a) describes a situation in which the domestic currency is fixed

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Part 5 Financial Markets

S

Exchange Rate, E

t

(foreign currency/

domestic currency)

Quantity of

Domestic Assets

E

1

D

2