Bretton Woods system

Topic: Balance of Payments and Exchange Rates · NCERT: Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

The Bretton Woods system (July 1944 – 1971/73) was an adjustable-peg system. Each currency had a fixed par value (an officially announced price) against the US dollar. Only the dollar could be converted into gold, at $35 per ounce, and only by foreign central banks. The IMF watched over the system.

It matters because it shaped the world economy after World War II. It gave us the IMF and the World Bank, and the reasons it collapsed still explain today's managed float and the power of the dollar.

Cross-rate rule: Rate between any two currencies = (units of currency A per $1) × (dollars per unit of currency B)

Explanation

How the system worked

• Where it began. A conference at Bretton Woods, New Hampshire, USA, in July 1944. It set up two institutions:
• the IMF (International Monetary Fund), which kept exchange rates stable and lent money for short periods to countries with BoP (balance of payments, the record of a country's money dealings with the rest of the world) problems
• the IBRD (International Bank for Reconstruction and Development, part of the World Bank), which gave long-term loans to rebuild and develop countries

• These two are called the Bretton Woods twins.

• Adjustable peg. Each currency was fixed to the dollar. A country could change its par value only to correct a "fundamental disequilibrium", meaning a deep BoP imbalance that would not go away. So it was not a free float and not a rigid fix either.

• Gold–dollar link. Only the dollar could be turned into gold, at $35/oz, and only foreign central banks could do this. Other currencies reached gold only through the dollar.

• So it was a gold-exchange standard with the dollar at its centre.

• Worked example (cross rate). Suppose the par values are ₹4.76 = $1 and £1 = $2.80.

• £1 = 2.80 dollars × 4.76 rupees per dollar ≈ ₹13.33
• Once every currency was pegged to the dollar, every cross rate was fixed as well.

Why it was built this way

• Lessons from the past. The gold standard (c. 1870–1914) broke down in World War I. The interwar gold-exchange standard was weak. In the Great Depression, Britain left gold in 1931.
• Beggar-thy-neighbour policies. After that, countries cut the value of their currencies one after another (competitive devaluations) and fought trade wars. Each tried to win exports at the others' cost.
• The fix. Bretton Woods tried to get the stability of fixed rates while avoiding two problems:
• the painful deflation (a general fall in prices and wages) that the gold standard forced on countries

• the chaos of the 1930s, where each country acted alone

• What it gave up. Under the trilemma (a country cannot have a fixed rate, free capital flows and its own monetary policy all at once), Bretton Woods gave up free capital flows.

The Triffin dilemma: the flaw inside

Robert Triffin (1960) showed that the system carried the seed of its own collapse.

• The world needed more dollars.
• World trade was growing → countries needed more dollars to pay for it (world liquidity, meaning enough money to keep trade moving)

• → so the US had to run BoP deficits to send dollars abroad

• But more dollars abroad weakened trust.

• Dollars held abroad kept growing → the US gold stock could back fewer and fewer of them at $35

• → people began to doubt the US could keep its promise → confidence in the dollar fell

• In short: the reserve country cannot both supply enough liquidity and keep confidence in its currency.

• Response: the IMF created the SDR in 1969 (Special Drawing Right, an extra reserve asset) to add to reserves when gold and dollars were not enough.

How it ended (1971–76)

• Nixon shock (15 August 1971): the US "closed the gold window". Dollars could no longer be turned into gold.
• Smithsonian Agreement (December 1971): countries set new pegs and the dollar was devalued. The new pegs did not last.
• Generalised float (by 1973): major currencies began to float, which means demand and supply set their value.
• Jamaica Accords (1976): these made floating legal (through the IMF's Second Amendment) and demonetised gold, so gold lost its official role as the unit of value.

In India

• Founding member. India was a founding member of the Bretton Woods institutions (IMF and IBRD).
• Under the system. The rupee had a par value against the dollar, like every member currency. Its rates with other currencies, such as the pound, followed from the dollar pegs.
• After the collapse. The world moved to managed floating from 1973. India's own path:
• 1991 BoP crisis: India turned to a Bretton Woods institution for help. The IMF approved an upper credit tranche Stand-By Arrangement (a loan that comes with policy conditions) of SDR 1,656 million (≈ US$2.2 bn) on 31 October 1991 [4].
• 1993: India moved to a market-determined exchange rate.

• 1994: India adopted current-account convertibility, meaning the rupee can be freely changed for trade and other current payments.

• The link today. India still holds IMF-linked assets in its forex reserves: SDRs and the Reserve Tranche Position. India's IMF quota share is about 2.75% (verify current).

Don't confuse with

• Gold standard (c. 1870–1914): every currency was fixed directly to gold, and BoP gaps closed automatically through gold flows (the price-specie-flow mechanism). Under Bretton Woods, only the dollar was convertible into gold, and pegs could be changed.
• Bretton Woods twins (IMF and IBRD): these are the institutions set up in 1944, and both still exist. The Bretton Woods system was the exchange-rate arrangement, and it ended in 1971–73.
• Smithsonian Agreement (Dec 1971) vs Jamaica Accords (1976): Smithsonian tried to save fixed pegs at new rates. Jamaica made floating legal and demonetised gold.
• Managed float (from 1973): the market sets the rate, and the central bank steps in only to smooth sharp swings. There is no announced par value to defend, unlike the adjustable peg.

Prelims Hooks

• The Bretton Woods conference (July 1944, New Hampshire, USA) created the IMF and IBRD. India was a founding member.
• The dollar was convertible into gold at $35/oz, and only for foreign central banks. Other currencies were pegged to the dollar. It was an adjustable peg, not a free float.
• A par value could change only to correct a "fundamental disequilibrium".
• Sequence trap: Nixon shock (Aug 1971) → Smithsonian Agreement (Dec 1971) → generalised float (1973) → Jamaica Accords (1976, gold demonetised).
• Triffin dilemma (1960): the reserve-currency country must run deficits to supply liquidity, and those deficits erode confidence in its currency.
• SDR (1969) was created to add to reserves under Bretton Woods. It is not a currency.

Mains Points

• The trilemma trade-off. Each regime gave up one goal:
• The gold standard gave up monetary independence.
• Bretton Woods gave up free capital flows.
• Today's managed float gives up full fixity, and the RBI steps in only to smooth swings.

• As capital began to move more freely across borders, fixed pegs became harder to defend, which helps explain the collapse. This is a useful frame for GS-III answers on exchange-rate policy.

• The Triffin logic still applies. The dollar is still dominant, with about 43% of SDR weight [3].

• Heavy use of the dollar exposes emerging markets to US monetary tightening.

• This explains India's push for rupee trade settlement and bigger forex reserves.

• The legitimacy of the Bretton Woods institutions (GS-II). The 16th Review raised IMF quotas 50% with no realignment [2].

• So India (about 2.75% share) and other emerging economies remain under-represented compared with their weight in the world economy.
• The G20 and BRICS demand a new quota formula under the 17th Review [2] to reflect today's world economy.

Related concepts

• International monetary system
• Gold standard
• Triffin dilemma
• Reserve currency
• IMF quota
• Reserve tranche position
• Special Drawing Rights
• Washington Consensus
• Structural adjustment programme

Read more

• The international monetary system: gold standard, Bretton Woods and the IMF