Bretton Woods System:

The Collapse of Fixed

Exchange Rate System
S M Shafi
Department of Business &
Financial Studies
University of Kashmir
• The IMF was instituted soon after the 2nd
World War to facilitate smooth functioning
of International Trade.

• It was thought that a system of fixed

exchange rates would be necessary for
the smooth functioning of international
finance
 The Original Scheme of IMF
provided:
• Each member-country should declare the
external value of its currency in terms of
gold and US dollar. This was known as
the ‘Par Value’
• The value of US dollars was fixed at US $
35 per ounce of gold. The USA
committed itself to convert dollars into gold
at the above official price. Cont………
 The Original Scheme of IMF
provided:
• Following the above, the monetary
reserves of member-countries came to
consist of gold and US dollars.
Consequently the US Dollar got the
position of the reserve asset.
• Each country agreed to maintain the
market value of its currency within a
margin of 1% of par value. Any variation
will be corrected by govt. intervention
 The Original Scheme of IMF
provided:
• Members free to devalue their currencies. But, if
the devaluation exceeded 10% of the par value,
approval of the IMF necessary.

• IMF might approve it or advise a lower rate.

However, it had no power to reject it.

• For chronic problems, devaluation was needed

no formal approval from IMF.
• For about two decades, the system went
smoothly but then it began to surface the
shortcomings.
• Drawbacks:
• 1) International Trade Outpaced
International Liquidity – countries began to
face BOP problems. Increase in
international liquidity depended upon
availability of gold Conti…..
 Collapse of the System
• The supply of gold did not increase
because its official price was fixed at US $
35 per ounce of gold
• With inflation and increased cost of
mining, countries found it uneconomical to
mine gold.
• Under the system dollar was equated with
as it was the only currency that was
convertible into gold
 Collapse of the System
• Dollar Hoarding by every country
• If only a portion of the dollars outside US
were to be converted into gold, it would
have collapsed the Federal Reserve
Bank of USA
 Collapse of the System
• Added to this US experienced a heavy
deficits in their BOP position. The supply
of dollars in the forex markets
increased to a great extent that led to
fall in the value of dollars.

• As a corrective measure US was advised

to devalue its currency
 Collapse of the System
• US did not heed. To maintain dollar’s prestige
and further, it thought that the number of
countries would suffer as they maintain huge
reserves of dollar.
• Thus instead of devaluing dollars US resorted to
a unilateral and unexpected step on 15th August
1971. The convertibility of dollar into gold
was suspended and a surcharge of 10% on
Imports was levied
 Collapse of the System
• These measures completely destablised
the exchange markets. Some major
countries like Japan and West Germany
took steps to rescue the dollar by
purchasing it in huge quantities. This
action could not however stabilize the
Forex markets and therefore, some
countries decided to float their currencies
in exchange markets
 Smithsonian Agreement
• The major industrialized countries came
together to give a collective thought to this
vexed problem. Ten countries got
together:( Group of Ten)
• USA, Canada, Britain, West Germany,
France, Italy, Holland, Sweden and
Japan met at Smithsonian Building in
Washington during Dec.1971
 Smithsonian Agreement
• Under the Agreement:
• US dollar was devalued by 7.87% and the
new gold parity was fixed US $ 38 per
ounce of gold instead of $ 35 earlier. But
this devaluation was not enough to set
things right. The other major countries
decided to devalue their currencies like
Japan and Germany. Wider band of
fluctuation: from 1% to 2.25%.
 Collapse of the Smithsonian
Agreement
• US faced unprecedented BOP deficit for
the year 1971 characterised by increased
imports due to domestic boom.
• Dollar continued to fall in the exchange
market. A number of countries tried to
save dollar by going for huge purchases.
• No remedy. Hence USA devalued dollar
for the 2nd time on 13th Feb 1973. The
extent of devaluation was 10%
 Smithsonian Agreement
• US removed the surcharge of 10% on its
imports.
• Non-convertibility of Dollar into Gold
continued
 Collapse of the Smithsonian
Agreement
• The gold value was also increased from $
38 to US $ 42.22 per ounce of gold.
• Following second devaluation of US dollar
many countries including Germany, UK
started floating their currencies. Thus the
Smithsonian Agreement came to an end
 Abolition of Gold System and
Emergence of SDR
• The turmoil in the exchange rate
continued.
• Major currencies continued to float
• On the recommendation of 20 member
countries IMF was reformed with no place
for gold and new reserve currency as
SDR Conti……
 Abolition of Gold System and
Emergence of SDR
• The official price of the gold was abolished
in November 1975, putting an end to Gold
era. The countries were free to purchase
or sell for monetary gold at the prevailing
market price.
• SDR emerged as the International
currency. USA opposed. USA advocated
floating rates, while as France was for it.
 Special Drawing Rights (SDR)
• Created in 1969, IMF currency.
• Currently 5 currencies make up the basket
of currencies for SDR
– 39% USD, 21% DM, 18% JY, 11% FF and
11% GBP
– To replace Gold and USD as a reserve
currency and to be used against speculative
attacks
• SDR 1 = USD 1.30[ the initial exchange rate]
• SDR 1= 0.664768 [ Current ]
• Interest Rate= 0.06%
 SDR Allocation
• Each member is assigned a quota
(expressed in SDRs, Special Drawing Rights)
subscription of capital to the IMF
• Member’s quota determines its voting power
– Each member has 250 basic votes plus one
additional vote for each 100,000 SDR)
Current Quota Values (In mil. SDR)
Argentina: 2,117; Bulgaria: 640; Egypt: 944,
France:10,739; Germany: 13,008; Greece: 823;
Mexico:2,586; Russia: 5,945; Spain: 3,049; Turkey:
964; UK 10,738; US:37,150
2nd Amendment to the AOA of IMF
• Every member country is free to choose its
own exchange rate system.
• The present system can be termed as a
‘managed float’.
• The major currencies like US Dollar, Yen,
Pound-Sterling are floating .,i.e. their
exchange rates are determined by market
• Cont….
2nd Amendment to the AOA of IMF

• Some currencies are pegged to SDR like

Burmese Kyat, Egyptian Dollar
• Some currencies are pegged to a major
currency. e.g., Sri Lankan Rupee is
pegged to Pound-Sterling
• For some currencies rates are based on a
basket of currencies e.g., Indian Rupee
 Fixed and Floating Exchange
Rates
• Under Gold standard, Fixed Exchange Rate
system referred to stabilizing exchange the
exchange rate with the Mint Par Value. The
gold system is abolished
• Today, Fixed exchange system refers to
maintenance of external value of the
currency at a pre-determined level.
Whenever, the exchange rate changes from
this level, it is corrected by official
Intervention
 Fixed and Floating Exchange
Rates
• For example, when IMF was instituted,
every member country was asked to
declare the value of its currency in dollars
and gold. The market rates were allowed
to fluctuate within a narrow band of margin
from this level.
 Fixed and Floating Exchange
Rates
• If the exports of the country exceed
imports, the demand for the local currency
in the exchange market will rise. This will
raise the value of the currency in the
market. Where the increase in value is
beyond the support point, the central bank
of the country intervenes in the market.
• Sells local currency and acquires foreign
currency
 Fixed and Floating Exchange
Rates
• Due to higher imports, the country may
have deficit on BOP. The foreign reserves
of the country get depleted because local
currency has to be purchased from the
dealers at the cost of forex reserves.
• Under fixed rates, devaluation can be
avoided by way of mutual agreement
between countries like India and England
 History of Rupee
• When India Joined IMF, Rupee was
valued equivalent to 0.268601 grams of
gold.
• Rupee was devalued in June 1966 by
37.5% and the parity of the rupee was
fixed at US $ 0.13333, equivalent to a gold
parity of 0.118489 grams of fine gold per
rupee
• Dollar-Gold Parity:
• US $ 35 US $ 35
• ----------------------= ------------
• 1 Ounce of Gold 28.34 grams

• US $ 1.23 per Gram of Gold

• Gold-Dollar Parity:
• 1 Ounce of Gold 28.34 grams
• ----------------------= -----------------
• US $ 35 US $ 35
•
• 0.8097 grams of gold per $

• Indian Rupee= 0.268601 grams of gold

• therefore exchange rate= 0.8097 grams
• ----------------------= 3.01 RS.
• 0.268601 grams
•
• 1966 when India devalued its currency by 37.5%
• Rupee – Parity with Gold was fixed as
• 0.118489 grams of gold

• Dollar parity with gold was = 0.8097 grams

• Thus rupee-dollar exchange= ----------------------
• 0.118489 grams
• Rs.6.83 per 1 US Dollar
•
 History of Rupee
• In Dec. 1971, the Smithsonian Agreement
brought some order with a wider margin of
2.25% on either side of fluctuation.
• Rupee was repegged to Pound-Sterling at the
central rate of Rs. 18.96 per Pound-Sterling.
• With the floating of Sterling , Indian rupee also
floated and as sterling depreciated so did the
rupee. Thus GOI delinked the rupee from the
Sterling
 Intervention Currency Vs Pegging

• Intervention Currency for India is Pound-

Sterling. The RBI stands to purchase or
sell Pound-Sterling to any extent with a
view to maintaining the stability of
exchange rate of rupee.
• Pegging a currency would mean having a
parity between the domestic currency and
the currency to which it is pegged
 Rupee- Rouble Exchange rate
• The Arrangement for determination of
rupee-roubles exchange rate presents a
good example of the effect of bilateral
agreements on exchange rates.
• USSR occupied a special position in
India’s trade. It was the 2nd largest trader
after UK. It extended large scale economic
credits for dev.of agri, indus, mining and
oil exploration