Fixed Exchange Rates, 1945-1973

Fixed Exchange Rates, 1945-1973

The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-World War II period of reconstruction and rapid growth in world trade. However, widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks eventually resulted in the system‘s demise. The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately, the United States ran persistent and growing deficits on its balance of payments. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually, the heavy overhang of dollars held abroad resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold.

On August 15, 1971, President Richard Nixon was forced to suspend official purchases or sales of gold by the U.S. Treasury after the United States suffered outflows of roughly one-third of its official gold reserves in the first seven months of the year. Exchange rates of most of the leading trading countries were allowed to float in relation to the dollar and thus indirectly in relation to gold. By the end of 1971 most of the major trading currencies had appreciated vis-à-vis the dollar. This change was – in effect – a devaluation of the dollar.

In early 1973, the U.S. dollar came under attack once again, thereby forcing a second devaluation on February 12, 1973, this time by 10% to $42.22 per ounce. By late February 1973, a fixed –rate system no longer appeared feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened, most currencies were allowed to float to levels determined by market forces. Par values were left unchanged. The dollar had floated downward an average of 10% by June 1973.

Fixed versus Flexible Exchange Rates:

A nation‘s choice as to which currency regime it follows reflects national priorities about all facets of the macro economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may then change as priorities change. At the risk of overgeneralization, the following observations explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer fixed exchange rates.

  • Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses.
  • Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.
  • Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) to be used in the occasional defence of their fixed rate. As the international currency markets have grown rapidly in size and volume, this need has become a significant burden to many nations.
  • Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation‘s economy changes, and as trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this change to happen gradually and efficiently, but fixed rates must be changed administratively-usually too late, with too much publicity, and at too great a one-time cost to the nation‘s economic health.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

Leave a Reply

Your email address will not be published. Required fields are marked *


*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>