Reserve Currency System Established at the Bretton Woods Conference - dummies

Reserve Currency System Established at the Bretton Woods Conference

By Ayse Evrensel

The reserve currency system that was established at the Bretton Woods conference is a version of the gold standard. In this system, one of the world currencies is identified as the reserve currency, and the reserve currency is pegged to gold. Then all other currencies are pegged to the reserve currency.

Between the end of World War II and the end of the Bretton Woods system in the early 1970s, the dollar was the reserve currency; almost every country pegged its currency to the dollar.

In this system, even though the U.S. had to have gold reserves, other countries could do so but didn’t have to. However, nonreserve currency countries had to keep sufficient dollar reserves in order to intervene in their currencies by buying or selling the dollar to maintain the fixed exchange rates.

Central banks of nonreserve currency countries held a large portion of their international reserves in U.S. Treasury bills, as well as short-term dollar deposits, which were (and are) highly liquid.

As in the case of any metallic standard, the reserve currency system also implies fixed exchange rates. Because under this system the dollar was convertible into gold and other currencies were pegged to the dollar, all cross rates were automatically fixed as well.

Suppose that the French franc–dollar and German mark–dollar exchange rates are FFR2 per dollar and DM1.5 per dollar. The French franc–German mark exchange rate thus would be FFR1.33 per German mark (2 / 1.5). If the French franc–German mark exchange rate were any different than FFR1.33, arbitrage would eliminate any exchange rate other than the fixed cross rates.

Suppose that the French franc–German mark exchange rate is FFR1.60. In this case, you could sell $100 to the Bundesbank in Germany for DM150 ($100 x 1.5), sell your German marks to the Bank of France for FFR240 (DM150 x 1.60), and sell your French francs to the Fed for $120 (FFR240 / FFR2), making $20 in the process.

(However, this was not possible because the U.S. didn’t buy or sell gold at the Bretton Woods price.)

Time to take the lead

In the reserve currency system, the reserve currency country has a special position: It has more room to conduct monetary policy to achieve the internal balance. Therefore, the reserve currency country can attempt to maintain its internal balance through monetary policy without affecting its external balance.

However, other countries that peg their currency to the reserve currency cannot change their monetary policy without affecting their reserves and messing up their external balance. Therefore, whenever the reserve currency country changes its monetary policy objectives, all other countries have to accept it.

For example, if a non-reserve currency country increases its money supply, it will lead to a decline in its international reserves. The reason is that an increase in the money supply decreases the interest rate in this country relatively to that of other countries. As investors flee this country in search for higher interest rates, an excess demand arises for foreign currencies, which revaluates the other countries’ currencies.

But such a change in the exchange rate goes against the fixed exchange rates and maintenance of the external balance. Therefore, countries whose currencies are revalued engage in interventions in foreign exchange markets, where they can buy the assets of the reserve country with their own currency. This situation then increases the supply of these currencies, decreases interest rates, and devalues these currencies.

Power has its privileges

In fact, in a reserve currency system, the reserve currency country doesn’t have to intervene in the foreign exchange market to maintain the fixed exchange rate. Unlike in other countries, the central bank of the reserve currency country doesn’t have to buy or sell currencies in the foreign exchange market.

The objective of the reserve currency country is to peg the reserve currency to gold. For example, the Federal Reserve was responsible for holding the dollar price of gold at $35 an ounce. Therefore, although the U.S. had more freedom to conduct monetary policy as the reserve currency country, its freedom had limits.

For example, excessively expansionary monetary policy in the U.S. would make the gold parity of $35 for an ounce overvalued and pressure the gold parity to increase. A speculative attack on the dollar then would ensue. To avoid a possible decline in the value of their dollar reserves, other countries would attempt to sell their dollars in exchange for gold, depleting the gold reserves of the Federal Reserve Bank.

Clearly, the reserve currency system put the U.S. in a privileged position. The U.S. got away with the reserve currency system for essentially three reasons:

  • The basic gold standard, in which all countries peg their currency to gold and hold gold reserves, wasn’t attractive during the Bretton Woods conference because the Soviet Union was one of the major gold producers in the world.

  • The Soviet Union did not attend the Bretton Woods conference, and the wedge between the Soviet Union and the West was growing.

  • The U.S. emerged as the new superpower, taking the place Britain had occupied for so long. With the U.S. as the new economic and military power, the dollar became the reserve currency.