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| Campaign poster showing William McKinley holding U.S. flag and standing on gold coin “sound money”, held up by group of men, in front of ships "commerce" and factories “civilization”. (Photo credit: Wikipedia) |
From U.S. Department of State
Nations attempted to revive the gold standard following World War I, but it collapsed entirely during the Great Depression of the 1930s. Some economists said adherence to the gold standard had prevented monetary authorities from expanding the money supply rapidly enough to revive economic activity. In any event, representatives of most of the world's leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. Because the United States at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold, the leaders decided to tie world currencies to the dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce.
Under the
Bretton Woods system, central
banks of countries other than the
United Stateswere given the task of maintaining fixed
exchange rates between their currencies and the dollar. They did this by intervening in foreign exchange markets. If a country's currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the value of its currency. Conversely, if the value of a country's money was too low, the country would buy its own currency, thereby driving up the price.
The
Bretton Woods system lasted until 1971. By that time,
inflation in the
United States and a growing American
trade deficit were undermining the value of the dollar. Americans urged
Germany and Japan, both of which had favorable payments balances, to appreciate their currencies. But those nations were reluctant to take that step, since raising the value of their currencies would increases prices for their goods and hurt their exports. Finally, the
United States abandoned the fixed value of the dollar and allowed it to "float" -- that is, to fluctuate against other currencies. The dollar promptly fell. World leaders sought to revive the
Bretton Woods system with the so-called
Smithsonian Agreement in 1971, but the effort failed. By 1973, the
United States and other nations agreed to allow
exchange rates to float.
Economists call the resulting system a "
managed float regime," meaning that even though
exchange rates for most currencies float, central
banks still intervene to prevent sharp changes. As in 1971, countries with large trade surpluses often sell their own currencies in an effort to prevent them from appreciating (and thereby hurting exports). By the same token, countries with large
deficits often buy their own currencies in order to prevent
depreciation , which raises domestic prices. But there are limits to what can be accomplished through intervention, especially for countries with large trade deficits. Eventually, a country that intervenes to support its currency may deplete its international reserves, making it unable to continue buttressing the currency and potentially leaving it unable to meet its international obligations.
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