| | | | | | | Curiosity 17.1: What Was the Bretton Woods System? | | | | | | | | | | In 1944, when an Allied victory was certain, the Allies held a conference at Bretton Woods, New Hampshire, to discuss what kind of currency exchange rate system the world should adopt after the war. Influenced heavily by its most prominent participant, John Maynard Keynes, countries decided to have all central banks buy and sell their own currencies so as to fix their currency in terms of U.S. dollars, with gold or U.S. dollars serving as reserves. Any country experiencing high inflation, and thus a balance of payments deficit, would under this system be subjected to an automatic harsh discipline: it would be forced to shrink its money supply, which would lower its inflation and thereby restore equilibrium in its international sector. The only exception was the United States, which could ignore its balance of payments deficits because it, and it alone, could print reserves U.S. dollars to cover any loss of reserves. | | | | | | | | | | The conference also established the International Monetary Fund (IMF) to provide loans to countries having temporary difficulties dealing with balance of payments problems. It also created the International Bank for Reconstruction and Development, commonly called the World Bank, to make long-term loans to assist developing countries building infrastructure such as dams and roads. | | | | | |
| | | | | essence everything was measured in U.S. dollars. As a result, the United States could simply print U.S. dollars to cover its balance of payments deficit, eliminating any automatic contraction of the money supply. Consequently, the rest of the world was forced to experience U.S. monetary policy and inflation rate. | | | | | | | | | The bottom line here is that under a fixed exchange rate, a small, open economy loses control of its monetary policy, which is forced to be identical to that of the larger country to whose currency its exchange rate is fixed. Note that this analysis corroborates the result of the preceding chapter: monetary policy is ineffective under a fixed exchange rate. | | | | | | | | | 17.2
Inflation With a Flexible Exchange Rate | | | | | | | | | The fixed exchange rate system described in curiosity 17.1 was attractive to the United States because it could do what it wanted and other countries had to adjust. Of course, if the United States created a big inflation, other countries could decide to abandon the fixed exchange rate system and no longer tie their currency to the U.S. dollar, thereby escaping the high American inflation. This sequence of events is exactly what happened during the Vietnam war, causing the world to move to a flexible exchange rate system. | | | | | | | | | Consider the same example: 8 percent inflation in America and 5 percent inflation in the rest of the world, but with a flexible exchange rate. Now the balance of payments deficit in | | | | |
