Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.
After the Second World War, the United States became the economic powerhouse of the world. Under the Bretton Woods Agreement of 1944 all major currencies in the Western world were set to a fixed exchange rate against the U.S. dollar. This became known as pegging the currencies to the U.S dollar. All countries participating agreed to keep the market exchange rate of their currency within a plus or minus 1% band of the pegged rate. The participants would intervene in foreign exchange markets by buying or selling their own currency to maintain the value of their currency within the agreed upon band. The process of supply and demand would then return the currency to within the agreed upon band.
The Bretton Woods Agreement effectively made the U.S. dollar the reserve currency for the Western world. The U.S. dollar anchored currencies around the world. The United States separately agreed to link the dollar to gold at $35 per ounce. Foreign nations could exchange dollars for gold when they wished. The purpose of this agreement was to further extend confidence in the dollar.
Changing Economic Climate
Unfortunately, the international economic situation began changing in the 1960s. Presidents Kennedy and Johnson attempted to contain exchange rate problems through a series of measures designed to support the dollar. Unfortunately, these measures were not wholly successful. By 1971, the U.S. had been financing a large ground and air war in Vietnam, imports had grown, and inflation was running at almost 6% annually. More U.S. currency was needed for international trade, and the money supply increased. The U.S. was now running a large trade deficit and dollars continued to flow overseas. Foreign exchange traders believed the U.S. currency's devaluation was imminent. As a result, they increasingly sold dollars and caused periodic runs on the currency.
Other nations, notably Switzerland and France, accumulated large numbers of dollars and demanded redemption for gold. The U.S. had pledged to do this, and its gold reserves began to decline. This caused the U.S to consider abandoning the fixed gold and dollar exchange rate. On August 15, 1971, President Nixon imposed a 90-day wage and price freeze to curtail inflation and a 10 percent import surcharge. The surcharge was an attempt to dissuade imports and reduce the trade deficit. He also ended the conversion of U.S. dollars into gold. These decisions were made without consultation with the international community and were labeled Nixon Shock by international leaders. They saw these actions as a shocking display of unilateralism on the part of the United States. Nixon's actions were more popular at home and were applauded by the American public. Another attempt was made to fix exchange rates but was not successful. The international community responded by removing their currencies from the Bretton Woods Agreement and allowed their values to float freely in the marketplace by 1973.
As a result of Nixon Shock, the Federal Reserve System (which controls the money supply in the United States) can respond to economic crises by expanding or shrinking the money supply more easily. For instance, in recent times the Federal Reserve has greatly expanded the money supply to answer the challenges of the financial crises of the first decade of this century. The Bretton Woods Agreement would have hindered this action. Freely floating currency does have its risks though. International traders and investors feel more uncertainty than ever before. Hedging strategies have become more and more sophisticated and prevalent to offset this uncertainly.
The Bretton Woods Agreement of 1944 required Western nations to peg their currencies to the U.S dollar. The dollar became the reserve currency for the world. The U.S. also agreed to convert dollars into gold at the request of foreign nations. Due to a deteriorating trade imbalance, an increase in the money supply, the cost of financing the Vietnam War, and domestic inflation, President Nixon abandoned the Bretton Woods Agreement in 1971. This action was done without consulting our foreign partners and become known as Nixon Shock. As a result of Nixon abandoning Bretton Woods, the Federal Reserve gained greater flexibility in monetary policy.
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