[Economy] Bretton Woods and Fixed Exchange Rate system : Meaning Explained

SubscribeEconomy89 Comments

Mitrapal Philosophy
  1. What is Bretton Woods?
  2. Why is important?
  3. Result of Bretton Woods
  4. Main Players in this Conference
  5. Impact of World War II on Economy
  6. Agenda of conference
  7. Fixed Exchange Rate system.
  8. Roosevelt Vs Mohan:
  9. Fast forward to 1970s
  10. Inflation and Gold Prices
  11. Do we need Bretton Woods?

While reading newspaper columns about global economy or Eurozone crisis etc. you may have come across a sentence, multiple times : “we need another Bretton woods.” so,
What is Bretton Woods?
It’s a place in New Hampshire State of USA, just like BASEL is a city in Switzerland.
Why is important?

  • In 1944, President Roosevelt hosted a conference here, to rebuild the world economy, after Second World War.
    Delegates of 44 allied nations (मित्र राष्ट्र) had came to participate in this conference.
  • Officially it is known as United Nations Monetary and Financial Conference, commonly known as Bretton Woods because of the place where it was held.
  • This conference resulted into creation of four extremely important things

Result of Bretton Woods

  • 1. IMF
    • They give short-term loans to help nations settle the balance of payment crisis.
    • They’ve a system called “SDR” :Special Drawing rights. (requires another article)
  • 2. World Bank
    • Officially known as IBRD :International bank for reconstruction and Development, that time
    • They give long term soft loans to rebuild the third world.
    • Soft loans= interest rate is very low. Sometimes you don’t have to pay back the principle.
  • 3. GATT (General Agreement on Trade and Tarrif) – later becomes WTO
  • 4. Fixed Exchange Rate system. (although Discarded in 1970s)
    • Explained in this same article.

Main Players in this meeting

  • Total 44 nations participated, but Main players were:
  • US President Franklin D Roosevelt
  • UK Prime Minister Winston Churchill
  • Lord John Maynard Keynes, Famous economist, UK treasury advisor.

India @Bretton Woods

  • Absent from the meeting: Mohan, Montek, Pranab, and Chindu (good otherwise they’d have messed up International Economy, just like they did to Indian Economy.)
  • India was represented by Sir C.D. Deshmukh, he was the first Indian Governor of RBI, This gentleman had cracked IAS exam in British-raj ,known as ICS exam in those days. And No, he is not the grandfather of Ritesh Deshmukh.

Back to the topic,

Impact of World War II on Economy

  • Second world war started in 1939, ended in 1945
  • There is large scale bombing and destruction in the world. Production has declined.
  • Agriculture, Dairy, Manufacturing, Export- everything is brought to standstill=huge inflation

Agenda of conference

  • Help rebuilt the World Economy. Provide money, loan, finance to needy nations. (World Bank)
  • After WW2, lot of colonies will get independence (India, Sri Lanka…), they’ll introduce their own national currencies without control of big superpowers (Britain, France etc) and they’ll enter in international trade in their own capacity.(Exchange rates, IMF)
  • Hence, Some rules/order had to be created to facilitate smooth international trade. (GATT)

Fixed Exchange Rate system.

What is Fixed Exchange Rate System?

  • Under this system, if RBI says $1=30 rupees, and you’ve 30 rupees and want to convert it in dollars but the Foreigners are willing to give 1 dollar to you…don’t worry.
  • RBI will accept your 30 rupees and give your one dollar out of its own reserve and vice versa.
  • Cons are obvious : When India is not exporting enough and not attractive enough foreign investment (in dollars) and still RBI keeps paying people in dollars, one day the bank lockers will be empty, there will be no dollars to pay. System will collapse.
  • But it has Pros (advantages) in the times of uncertainty- When you’re writing on a clean slate, after WW2, if every nation decides to have a fixed exchange rate system- it leads to stability and predictability in Exchange rates = good for foreign trade.

Roosevelt Vs Mohan: Pegging the Currencies

(Fictional, technically incorrect, imaginary)

President Roosevelt: ok I say we put fixed exchange rate system. Let’s fix the rates that 40 Rupees will equal to 1 dollar. 15 Yens will equal to 1 dollar. 12 Pounds will equal to 1 dollar and so on. In short, I’m pegging your currencies to US Dollar. Thus Dollar will be the international reserve currency. AND Your country’s RBI (central bank) will make sure these exchange rates don’t fluctuate more than 1% from these values.

Mohan: ya man, but what if the exchange rate fluctuates? for example, What If I start running my country in a totally pathetic and irresponsible manner and hence nobody wants to invest in India so supply of dollar is low but demand of dollar is high- because Indians love gold and we’ve to import crude oil and pay in dollars. In short, this will fluctuate the exchange rates between Dollar vs Rupee.

President Roosevelt: Let me ask you a question. Suppose Onions are selling 100 rupees a kilo because of low supply but suddenly farmers produce fresh new 50 million tonnes of onions and supply it to market, what will happen?

Mohan: Easy! Onion Price will drop down to 40 rupees a kilo because the supply has increased.

President Roosevelt: yes dude, the same way, whenever exchange rate fluctuates from our standard rate, you’ll tell your RBI to supply dollars from its own forex reserves in to the market to calm down the demand and bring the rate back to normal level.

If the reverse happens: (Onions are selling @ 2 rupees a kilo) then you tell your RBI to buy all Onions dollars using its own rupees, until the supply is reduced and price is back to normal.

Mohan: What nonsense is this? If 40 rupees equals 1 dollar but then what does 1 dollar equal to? What is the value of your own dollar? Why should we accept your dollar as international reserve currency?

President Roosevelt: I’ve fixed the value of your currency to my dollars. And I’m fixing the value of my own dollars to Gold. 1 ounce of Gold shall equal to 35 dollars. Meaning you walk in with 35 dollars in my RBI (Federal Reserve Bank of USA), and you’ll get one ounce of gold in return. Gold will remain precious forever. So, it’s not like we’re running the show in thin air. Dollars are backed by GOLD.

Mohan: ya man but what if my RBI doesn’t have enough dollars in its lockers? What will we do then?

President Roosevelt: don’t worry, come to IMF. They’ll arrange short term loans for you, in dollars.

Mohan: but still, why should we fix price of our currency to dollars? Why should we accept dollar as the reserve currency and not Yuan, Yen or Pound? Why should we accept you as our big boss?

President Roosevelt: Because I’ve the aukaat to pay enough gold, so I say dollars will be the international reserve currency. IF you’ve enough gold reserve in your RBI, come sit in the chair and we’ll see whether rupee is strong enough to become the international reserve currency or not.

Even Britain is so financially bankrupt after Second World War, they don’t have the guts to tell me set this exchange rate according to their Pounds. Btw, I also got some nuke missiles in my limousine.

Mohan: no no…I was just kidding man. I’m well aware that you’re the superpower both financially and militarywise.

President Roosevelt: Besides When we’ve a stable and fixed exchange system like this, it’ll ensure smooth and long term trade deals between merchants of various countries. When you don’t have fixed exchange rate system, it is bad for economy. For example, today your call-center boss may give you free lunch and coffee because $1=60 rupees but next day when value of rupee declines and it is $1=50 rupees, same boss will even stop running the water-cooler in your office. Third day when $1=40 rupees, He will just kick you out because outsourcing generate that much profit for him. Such uncertainty, is not good for economy.

And since Gold is in limited supply, Dollar will be spent carefully, and so your currency will be in spent carefully. i.e. Since currencies are ‘pegged’, you will not indulge in extravagant spending in subsidies, welfare schemes, tax-reliefs or debt-waivers to farmers. This ensures fiscal discipline => That ensures less Fiscal deficit = less inflation.
Mohan: Mr. President Sir, I think I got the point now. I’ll tell my RBI Governor here to sign the Bretton Woods agreement papers, because fixed exchange rate system sounds safe and good.

Fast forward to 1970s

  • As you can see, the fixed exchange rate system, is good for stable international trade environment, atleast on paper.
  • But this system can run smoothly only as long as USA has the aukaat to pay gold to every swinging dude that walks with dollars into their RBI (US Treasury).
  • Problem started with Cold War. Both USA and USSR (not Russia), are busy in an arms race, building new tanks, missiles and submarines every week.
  • They’re also giving huge donations and help to poor nations, in order to win their support and dominate the region. This is a non-productive activity, they’re basically wasting money.
  • Now, USA gets involved in a very lengthy and expensive Vietnam War from 1959 to 1975.

Inflation and Gold Prices

  • Fact: War leads to inflation
  • Fact: Inflation decreases the value of your money.
  • Fact: Gold becomes more expensive because of Inflation.
  • US still kept fixed value of 35 dollars = 1 ounce of gold. But thanks to this inflation, Gold is trading at higher price in open market – 40 dollars per ounce.
  • So there is an opportunity to make quick money, just tell the RBI manager to take suitcase full of dollars from RBI’s locker to US Federal Reserve, take their gold in return, and sell it to the local jeweler at higher market price and use this profit to fix india’s problems- poverty, education etc. (may be by starting another welfare scheme named after Nehru-Gandhi family.)
  • For a while, US Presidents had enough clout over international politics so that they could force other nations’ RBI managers not to indulge in such cheap profiteering. But Vietnam war is fast deteriorating America’s clout and now RBIs of various countries have started lining up with their suitcases full of dollars and they want gold in return.
  • 1971, President Nixon decides that if we continue giving gold for dollars, we will go bankrupt. There will be no gold left in our lockers. So I give up. I’m not going to let anyone exchange their dollars for my gold.
  • And thus Bretton Wood system breaks down.
  • 1973, World moves to floating exchange rate system.
  • What is Floating Exchange rate? Governments / Central Banks don’t fix exchange rates here. It is left to the Forex markets, private players and laws of supply and demand.Government /RBI will only intervene if there is huge fluctuation in the exchange rates.

Do we need Bretton Woods?

  • With respect to the Eurozone crisis (click ME), many columnists write “We need another Bretton Woods”.
  • They don’t actually mean that we need to move back to the same old Fixed Rate exchange system, in which every currency was pegged to Dollar and Dollar was pegged to Gold. Because that fixed rate thing is impractical in real life scenario, as we saw in above paragraphs.
  • Just imagine, if tomorrow World starts running according to Bretton Woods system, what will happen?
  • We know that China already has more than 1000 billion dollars in its Forex Reserves. So People’s Bank of China will send its Probationary officer with suitcases full of dollars and take away all the gold from Fort Knox*. They don’t even need to fight a war, USA will come down to its knees financially.
  • [*Fort Knox is a place in Kentucky State, US Government keeps the gold reserves in this place.]
  • In real life, not that China will actually do so, but the mere threat and possibility will keep USA on its toes. Hence US will not agree to Fixed Exchange rate in the first place.
  • There is no chance any other country will agree to become the ‘big brother’ and let their currency become the reserved currency and peg it to gold.
  • Especially India, because if we peg our 10,000 Rupees to one ounce of Gold and declare that we are the new international reserve currency, just like dollar before 1970s, What will be the Result? Pegged currency means Government can’t do extravagant spending in MNREGA. They’ll have to stop subsidy on diesel, kerosene, LPG and fertilizers, because they can dole out only as much rupees as the amount of gold held in RBI’s locker.
  • As You can understand, no political party has the guts to do that, hence no nation will want to become the big brother or Sacrificial goat (Bali kaa Bakraa) for “another Bretton Woods”.
  • So, The sentence “We need another Bretton Woods” is just a metaphor, to say that all the Presidents, Prime ministers and Economists of the world should meet up once again and hold conference in some gambling den, drink some Desi liquor (देसी दारू), watch some Item-song, brainstorm for new ideas and start something from scratch, totally new, Just like the Gentlemen at Bretton Woods did, in 1944.

Then what to do?

  • It could be anything, untried and untested before like-
  • China could agree that we’ll not dump our products in foreign market, we will not keep our yuan under-valued,
  • US could agree that we’ll bring back our troop from Afghanistan and cut down on our Defense Expenditure and its inflationary effect on world economy. We will also stop supporting Pakistan. Thus reducing defense Expenditure of India in the arms race= that will also reduce fiscal deficit of India= India could decrease taxes=boost for economy and world trade.
  • Iran could agree that we’ll stop our irrelevant obsession with nuke weapons and give up, So that UN removes the sanctions and our traders can make more money, thus improving the standard of living for Iranian aam-aadmis.
  • EU could agree that we’ll kick out Greece, because it’s just way too messed up beyond fixing.
  • And India could agree that we’ll bring all the black money from Switzerland and use it to finance our bogus Government schemes and subsidies instead of looting the aam-aadmi via direct and indirect taxes, to finance those things.
  • And finally you and I could agree that facebook is a waste of time, so a serious Aspirant should concentrate on his studies instead of uploading funny/motivational photos there.

Mrunal recommends

  1. (free) NCERT, NIOS, TN-Books 4 History,Geo,Sci
  2. Indian Polity M.Laxmikanth (Hindi | English)
  3. Spectrum: Modern History (Hindi | English)
  4. Maths: Quantam CAT Sarvesh Kumar
  5. Objective General English SP Bakshi
  6. Word Power made Easy -Norman Lowe
  7. Topic wise Solved Paperset by Disha

89 Comments on “[Economy] Bretton Woods and Fixed Exchange Rate system : Meaning Explained”

  1. sir.. im very much thankful for ur valuable info & ur approach to help d aspirants is simply superb..

  2. what a way to explain such a typical economic issue.Heads off to you sir…

  3. For example, today your call-center boss may give you free lunch and coffee because $1=60 rupees but next day when value of rupee declines and it is $1=50 rupees, same boss will even stop running the water-cooler in your office. Third day when $1=40 rupees

    but, if the rupee is going from 60 to 50 (then to 40) per dollar..then the value of rupee is strengthening against dollar…

    kindly clarify..

    1. yes the value of rupee is strengthening… but the call center will earn revenue in $ ( because its serves US clients ).
      So even if rupee is strengthening.. it is bad for exporters in the short to medium term.

  4. sir it was superb
    you have excellent method of making difficult topic very simple
    thanks

  5. a gr8 job sir.. untill recently the basis of fiwed exchange rate was a puzzler.. thanks a ton 4 ur effort in lucid and funny explaination

  6. FANTASTIC,THNX A LOT SIR

  7. mrunal sir…u r not only intellgent…but hv a superb sense of humour…..i m ur fan sir….chidambram nw ….chindu…lolzz

  8. Dear Mrunal, let me say that you have a God-gifted talent of writing. You make difficult concepts so easy and interesting like no one else can. But please dont try your hand in writing novels etc. coz we aspirants will lose our Mrunal whom we love so much.. Thanks a lot for this beutiful article..

  9. Thank you Mrunal! May God bless you. You are AWESOME!!!!!!

  10. Mrunal u r certainly a god gift..:) thankx a lott for such an article which written by u in a lucid form..:)

  11. tanks a lot sir g it is the great way to get people understand……………..thanx

  12. Best article read so far in Mrunal Site.. Way to go sir..

  13. Besides, since Gold is in limited supply, Dollar will be spent carefully, and so your currency will be in spent carefully. i.e. Since currencies are ‘pegged’, you will not indulge in extravagant spending in subsidies, welfare schemes, tax-reliefs or debt-waivers to farmers. This ensures fiscal discipline => That ensures less Fiscal deficit = less inflation.sir, plz elaborate it…thanks

  14. world war started in 1939 and ended in 1945 then how can american president Roosevelt hosted a conference in 1944 to rebuild the world economy, after Second World War…….plz once again clarify the dates..

    1. conference was only between allied nations(MITRA RASTRAs) of America

  15. Certainly you are a great man. Thanks a lot for wonderful and lucid explanations.
    I love the way you have presented humorously. Once again Thank You…

  16. how china is then clinging on to system of fixed xchange rate ? can nybody xplain?

  17. why china is clinging on to fixed xchange rate ? can nybody xplain??

  18. Dear Mrunal
    Its very difficult for me (atleast) to write a comment against any blog or knowledge sharing platform.
    But the way you write these articles is something prodigal and makes us feel to read long elaborate pages.
    Thanks to you
    One recommendation (Please make your site little more clear and segregated)

  19. Sir, You made complex topics also easy, and enjoyed reading your articles. Thanks

  20. way a way to teach…. fan of u sir..i

  21. HI sir ,

    Could you please tell me as starting from scratch which book I start with for Indian economy…. Also please explain me what are special drawing rights.?

  22. Awesome ..simplest n best way to teach ..u made economy as fun ….god bless u …

  23. I am not even preparing for any exam,I read that just because I like Mrunal’s sense of humour.

  24. sir, could throw more light on the concepts of
    SDR, FTP,balance of payment, how current account deficit happens and about capital account balance.
    the regular way you present the stuff.
    take this into regard sir
    thank you.

  25. sir u r awsome … no words

  26. Mrunal sir is the last resort for economics doubts.
    Thank you for your lucid explaination

Leave a Reply

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