From 1946 until 1971 the Bretton Woods System governed foreign exchange rate policies in the world economy. The foreign exchange rate is the rate at which one country’s currency can be converted into another country’s currency. The system took its name from Bretton Woods, New Hampshire, the 1944 site of the international conference of monetary officials who created it.
For an individual country foreign exchange rates determine the cost of imported products to domestic consumers and the price of domestic exports to foreign buyers. For example, the foreign exchange rate between British pounds and United States dollars determines the cost of a British pound if purchased by a United States dollar, and conversely, the cost of a United States dollar if purchased by a British pound. Therefore this exchange rate will determine the cost in dollars of British goods sold in the United States, and the cost in pounds of United States goods sold in Britain. Thus, foreign exchange rates determine the competitiveness of a country’s goods and services in the world market. Economies rise and fall with changes in foreign exchange rates.
Before World War I, the world economy was on a gold standard, which fixed the value of each country’s currency in terms of a fixed weight of gold, thereby setting exchange rates between currencies in the process. After World War I governments returned to the gold standard, but the result was unsatisfactory. The same governments abandoned the gold standard during the Great Depression, leaving foreign exchange rates free to float with varying degrees of government involvement.
The Bretton Woods System proposed to combine the stability of fixed exchange rates with the flexibility of floating exchange rates in a system of so-called adjustable peg exchange rates. Under an adjustable peg system, each country declared a par value of its currency in terms of gold and committed itself to buying and selling foreign currency and gold reserves to maintain this par value in foreign exchange markets. An individual country could not change the pegged value of its currency more than 10 percent without permission of the International Monetary Fund, a permanent international institution created by the Bretton Woods System.
In 1971 the Bretton Woods System came to an end because the United States needed to devalue its currency. The United States experienced a large outflow of dollars relative to inflow because of foreign expenditures from the Vietnam War and other obligations in foreign countries. By that time, however, most countries kept their currencies pegged to the value of the dollar rather than the value of gold, a practice that crept into the Bretton Woods System because gold monetary reserves were in short supply. In an effort to save the Bretton Woods System, the United States devalued its dollar relative to gold, but the outflow of dollars remained excessive. In 1973 the world economy went on a system of flexible exchange rates.
The Bretton Woods System kept alive a vestige of the gold standard when gold monetary reserves were inadequate to support the growth in world trade and money stock. It also provided stable exchange rates that reduced the risk and uncertainty associated with foreign trade, a factor that might have helped world trade recover from the disruption of world war. Perhaps its greatest accomplishment was the cooperation it fostered among trading partners in an important area of common interest.