The Breton Wood System
The Breton Woods System was introduced after the culmination of World War II. The system came into existence to address problems associated with shortages of the dollar supply during that period. However, the dollar shortage turned into a glut a decade later. This is because reconstruction efforts had been concluded, and thus the demand for the dollar had reduced. This contributed to the excessive flow of dollars in the global market.
Consequently, governments had to take remedial measures to deal with the dollar glut. Another contributor was the debate on the European Economic Integration as well as the use of a common currency. These efforts aimed to eliminate trade barriers among the member countries as well as create a common barrier to protect their companies from external competition.
European Union kept out non-member countries (i.e., United States) from the European market. In response, the American investors started to invest heavily in plants and businesses located in the member-states to evade barriers that could make it hard for them to compete in these markets. As a result, the American private investors contributed to the heavy flow of US dollars in the foreign exchange markets.
Unlike the international gold standard, the Breton Wood System advocates for state interventions in the Forex market to avert a drop in the exchange rate that goes beyond one percent of the targeted/pegged level. Countries that are signatory to the Breton Wood System are assigned an IMF quota. A quarter of the quota is in the form of gold reserve and the rest in the local currency. Thus, whenever a member country is experiencing an acute deficit in the balance of payment, it can borrow from the IMF to offset the imbalance.
Sometimes, borrowing from the IMF may not be necessary. A country experiencing a balance of payment deficit may have accumulated surpluses in the early periods. As a result, a country experiencing a deficit may trade-off with another country with a surplus to offset the imbalance. This is normally achieved through expansionary monetary policies such as dumping foreign currencies in the Forex market to allay the shortage caused by currency devaluation. They can also buy back the foreign currency during the surplus period.
Setting Exchange Rates
The exchange rate between two currencies should be set at roughly the normal rate that would have been set by the market forces in the long run period (i.e., approximately ten years). This may vary from one country to another on the basis of their unique economic, political, social, and environmental factors. Exchange rate adjustment should be made at least twice in a decade. For instance, assume that the US government has set the yen price of the dollar for an average level of 360 in a decade. When the US experiences a deficit, Japan will accumulate more US dollars, whereas, during the surplus period, the US will accumulate more Japanese yen.
Thus, after a decade elapses, the US would have accrued 360 yen for every dollar amassed by the Japanese banks. Therefore, the US and Japanese governments could decide to trade their foreign currencies using the pegged rate. In this case, the two governments can offset the imbalances in their balance of payment accounts without borrowing from the IMF or converting them into gold.
An increase in the global exchange value of the US dollar prompts upward movements along the demand and supply curves. An upward movement along the demand curve (Dc) corresponds to the decrease in US exports. On the other hand, upward movement along the supply curve (Sc) corresponds to the increase in US imports. The fluctuation of the value of the dollar in the international Forex market strengthens the impact of the government’s monetary policies.
This is because the stabilized exchange rate prevents the domestic monetary policies from achieving a stable value of the local currency in the Forex market. However, under a flexible exchange rate policy, the government can pursue both local and international financial commitments. In other words, flexible exchange rates increase government efficiency with respect to monetary policies in the domestic and international spheres.