After the World War I most countries wanted to return to the old financial security and a stable situation of pre-war times as soon as possible. Most of the countries had somewhat re-established the Gold Standard System by which every nations circulating money had to be backed by reserves of Gold. Due to major flaws in the Gold System, Weakening of the British Economy led to a deflationary environment creating mass unemployment, bankrupt companies, failure of credit institutions and hyper inflation in some countries.
The Bretton Woods conference was held in 1944 which created an international basis for exchanging one currency for another. It also let to the creation of the International Monetary Fund (IMF) and the World Bank (earlier known as International Bank for Reconstruction and Development) The IMF was designed to monitor exchange rates and lend reserve currencies to nations with trade deficits while the World Bank would provide the developing countries with Capital.
44 of the world nations who were members of these organizations contributed a fee to fund these institutions and the amount of each member contributed dictated its number of votes. The United States contributed the highest and enjoyed (still enjoys) a dominant position at the IMF.
In an effort to free international trade and fund the post World War II expenses each member agreed to maintain their exchange rate to the USD, plus or minus 1 percent. The US assured the world that their currency was the most dependable because of 2 main reasons:
· Half of the manufacturing activity in the WORLD was accounted in the US
· More importantly, the US held half of the world's GOLD as reserves
Under this system, Central Bankers of the world (excluding the United States) were to maintain fixed exchange rates between their currency and the USD. The central bankers would intervene in the foreign exchange markets and:
· If the countries currency was too high against the USD, the central bank would sell the its current and buy dollars hence depreciating its Currency internationally
· If the countries currency was too low against the USD, the central bank would buy its own currency, thereby allowing it to appreciate internationally
The system collapsed in 1971 when President Nixon severed the link between the dollar and gold and adapted monetization policy. This resulted into high Inflation in the US, Bank Failures, High Oil Prices etc. This action was also known as the “NIXON SHOCK”
