The Bretton Woods System: Study with Video Lessons, Practice Problems & Examples

The Bretton Woods system, established in 1944, replaced the gold standard with a fixed exchange rate system where the US dollar was pegged to gold at $35 per ounce. Countries fixed their currencies to the dollar, but only central banks could exchange dollars for gold. The system collapsed by 1973 due to an excess of dollars over gold reserves and resistance from countries to revalue undervalued currencies, leading to inflation and imbalances. This transition paved the way for the current managed float system, where supply and demand dictate exchange rates.

Bretton Woods System:Introduction

So after the gold standard was abandoned, a new system was put into place called the Bretton Woods system. The Bretton Woods System was essentially a new attempt to modify the gold standard. It was an exchange rate system implemented after abandoning the gold standard and it was used from 1944 to 1973. You can tell that this one didn't last very long either. It's named Bretton Woods because there was a conference in Bretton Woods, New Hampshire where the US pledged to buy or sell gold at a fixed rate of $35 an ounce. The US said that they would buy gold from other countries at this price of $35 per ounce. They set this fixed rate for the exchange rate of dollars to gold. They were still using gold as the basis for the system. Countries pledged to buy and sell their currencies at a fixed rate to the dollar. As the dollar fixed itself to the gold, countries fixed themselves to the dollar. They were going to buy and sell their currencies at a fixed rate to the dollar. This was still a fixed exchange rate system. By fixing their rates to the dollar, the exchange rates were also fixed between other countries. Because if you can get £2 for $1 or 3 pesos for $1, you could trade those £2 for 3 pesos or whatever, right? They're all fixed to each other. However, unlike the gold standard, no country was willing to exchange its paper money for gold. Only the US dollars would be exchangeable for gold. Other countries were not exchanging their money for gold. And even in the US, you couldn't go to a bank and redeem your money for gold. It was basically central banks that could redeem the money for gold. Generally, foreign Central Banks would be the ones redeeming for gold, not just any regular citizen. From the 1930s to 1970s, this is actually a pretty interesting fact that even I learned about here. It was actually illegal for American citizens to own gold. You could have, you know, jewelry or some like rare coins, but you weren't allowed to physically own gold as an investment during this Bretton Woods time. It was actually illegal to hold gold. What foreign countries did is they were committed to holding dollar reserves. So they would hold dollar reserves, which was basically like holding reserves for their gold there, right? And the International Monetary Fund was created to provide loans to Central Banks that were short of reserves. So when they didn't have the dollar reserves, the International Monetary Fund would make those loans to them. So, a big thing with these fixed exchange rates is that supply and demand are not at play. When we have a fixed exchange rate, we don't have supply and demand changing the exchange rate to match the equilibrium. And a fixed exchange rate is not necessarily equal to the equilibrium. Remember, when we have our graph, it's our standard supply and demand graph, right? And if we're not at equilibrium, well, we're either going to have a shortage or a surplus. If demand is high and supply is low, there's a shortage. So it depends on where that fixed exchange rate is whether we're going to have a shortage or surplus or if it's actually at equilibrium. This tended to lead to surpluses and shortages of different currencies based on an overvaluation or undervaluation. The IMF would try to keep up with this and if they noticed that there was a persistent surplus or shortage, they would adjust the fixed exchange rate between the dollar and that currency to make it balance out again. So that was basically how this system worked. Let's pause here and show how the Bretton Woods systems basically collapsed afterwards.

Bretton Woods System:Collapse

So there are two main reasons why the Bretton Woods system collapsed. The first was that by 1963, the dollars held by foreign central banks exceeded the gold reserves of the United States, okay? So, there were more dollars being held in reserves than the gold to back it up. And that means that if all of those banks went and turned in their dollars to get gold, there wouldn't be enough gold to match all those dollars. This rarely happened though. Central banks rarely redeemed their dollars for gold. But this was the foundation of the system, right? This is why the system tended to work was because of this promise that the US had made to buy the gold at $35 an ounce. And as this gap grew larger and larger, well, there started to become an uncertainty. The central banks began to doubt the US would be able to fulfill its promise of redeeming dollars for gold. So that was the first problem with the Bretton Woods system; there were just too many dollars for the amount of gold that was in reserves.

The second reason was that some countries with undervalued currencies were unwilling to revalue their currency. So remember, there were these fixed exchange rates and if we were in a situation where there was an undervalued currency like we have in our little graph right here, where the demand is greater than the supply because the currency is undervalued. Well, then the currency should be valued up to its equilibrium. However, these countries were unwilling to revalue, right? So, this led to an increase in the currency's value would lead to higher prices for their exports. Sorry. So the reason they didn't want to revalue was if they increased the value of their currency, it would lead to higher prices for their exports. And basically, firms were pressuring the government saying, hey, don't let them revalue our currency so it doesn't hurt our business, right? Because if the value of the currency goes up, the exports get more expensive and they can't make as many sales overseas. So the firms were basically pressuring the governments not to allow those revaluations, okay? And this caused bigger and bigger shortages in the currency and causing the governments to print money and inflation to happen, right? So it caused a lot of problems as well.

Eventually, controlling the fixed rates basically became too difficult, okay? And by 1971, President Richard Nixon abandoned the USA's commitment to redeem gold for dollars. And by 1973, the whole system was just abandoned in general. And that's where we got to the system we have today. The managed float system basically allows supply and demand to control the exchange rates. And then the governments might step in at some point, you know, if things start to get out of control, the government might buy or sell its own currency to try and manage its exchange rate. Okay?

So that's about it for the Bretton Woods system. Let's go ahead and pause and we'll move on to the next video.

Here’s what students ask on this topic:

What was the Bretton Woods system and why was it established?

The Bretton Woods system was an international monetary system established in 1944 to replace the gold standard. It aimed to create a stable exchange rate system post-World War II. Under this system, the US dollar was pegged to gold at $35 per ounce, and other countries fixed their currencies to the dollar. This arrangement was designed to provide stability and prevent competitive devaluations. The system also led to the creation of the International Monetary Fund (IMF) to provide financial assistance to countries facing balance of payments issues. However, it collapsed in 1973 due to imbalances and the inability of the US to maintain the gold-dollar convertibility.

Why did the Bretton Woods system collapse?

The Bretton Woods system collapsed primarily due to two reasons. First, by 1963, the dollars held by foreign central banks exceeded the US gold reserves, creating doubts about the US's ability to redeem dollars for gold. Second, some countries with undervalued currencies were unwilling to revalue them, leading to persistent imbalances. These countries feared that revaluation would make their exports more expensive and hurt their economies. The resulting inflation and imbalances made it difficult to maintain fixed exchange rates. By 1971, President Nixon abandoned the gold convertibility, and by 1973, the system was entirely abandoned, leading to the current managed float system.

How did the Bretton Woods system differ from the gold standard?

The Bretton Woods system differed from the gold standard in several ways. Under the gold standard, currencies were directly convertible to gold, and individuals could exchange paper money for gold. In contrast, the Bretton Woods system pegged the US dollar to gold at $35 per ounce, and other currencies were fixed to the dollar. Only central banks could exchange dollars for gold, not individuals. Additionally, the Bretton Woods system introduced the International Monetary Fund (IMF) to provide financial assistance to countries with balance of payments issues, a feature absent in the gold standard.

What role did the International Monetary Fund (IMF) play in the Bretton Woods system?

The International Monetary Fund (IMF) played a crucial role in the Bretton Woods system by providing financial assistance to countries facing balance of payments problems. When countries experienced shortages of dollar reserves, the IMF offered loans to help stabilize their economies. This support was essential in maintaining the fixed exchange rate system, as it allowed countries to manage temporary imbalances without devaluing their currencies. The IMF also monitored exchange rates and provided a platform for international monetary cooperation, helping to ensure the stability of the global financial system during the Bretton Woods era.

What were the main challenges in maintaining fixed exchange rates under the Bretton Woods system?

Maintaining fixed exchange rates under the Bretton Woods system faced several challenges. One major issue was the imbalance between the US dollar reserves held by foreign central banks and the US gold reserves, leading to doubts about the US's ability to redeem dollars for gold. Additionally, countries with undervalued currencies were often reluctant to revalue them, fearing that higher currency values would make their exports more expensive and hurt their economies. These imbalances led to inflation and economic instability, making it increasingly difficult to maintain fixed exchange rates. Ultimately, these challenges contributed to the system's collapse in 1973.