Question

How were exchange rates determined under the gold standard? How did the Bretton Woods system differ from the gold standard?

Short answer

Under the gold standard, exchange rates were determined by the gold content of different currencies, as currencies were convertible into gold. Under the Bretton Woods system, exchange rates were fixed relative to the U.S. dollar, which was itself pegged to gold. Thus, the Bretton Woods system revolved around stabilization of economies and financial aid for development, while the gold standard aimed at providing stability of exchange rates.

Step-by-step solution

Understand the Gold Standard

Under the Gold Standard, the value of a country's currency was tied directly to a specific amount of gold. Each country based its currency on either a direct gold ownership or gold bullion standard, meaning that the government guaranteed that it would exchange its currency for its value in gold upon demand. The exchange rate was thus determined by each country's set gold price.

Understand the Bretton Woods System

In the Bretton Woods System, each member country agreed to fix the value of its currency in terms of the U.S. dollar or gold. However, only the U.S. dollar was convertible into gold. This system essentially created a fixed exchange rate system where countries were obligated to intervene in foreign exchange markets to maintain their rates within a 1% band around the agreed-upon level.

Comparison between Gold Standard and Bretton Woods System

Under the Gold Standard, the exchange rate was determined by the gold content of different currencies. Contrarily, in the Bretton Woods system, the U.S. dollar replaced gold as the main standard of convertibility for the world's currencies; and hence, each country’s currency was pegged to the U.S. dollar instead of gold. While the gold standard emphasized the stability of exchange rates, the Bretton Woods system was more about stabilizing economies and providing financial assistance for economic development.

Key concepts

Gold Standard

The gold standard was one of the earliest systems used to regulate exchange rates. It connected the value of a country's currency directly to a specific quantity of gold. This meant that the government would guarantee the conversion of its paper money into a certain amount of gold upon request. The appeal of the gold standard lay in its ability to promote stability in exchange rates. Since every currency was pegged to gold, it ensured a consistent exchange rate that was predictable and stable.

This system facilitated smooth international trade as the rate of exchange was easily calculable due to the fixed gold prices. However, it also meant that a country's money supply was directly tied to its gold reserves, which could limit economic growth if gold reserves did not increase alongside the economy's growth. Furthermore, during economic downturns, adhering strictly to the gold standard could exacerbate the situation, as monetary policy was limited by the amount of gold held.

Bretton Woods System

The Bretton Woods system was developed in the mid-20th century as the international economy was recovering from World War II. It modified the principle of the gold standard by introducing the U.S. dollar as a central anchoring currency, with only the U.S. dollar being directly convertible into gold. This meant that countries would peg their currencies to the U.S. dollar, which in turn was pegged to gold, creating a system of fixed but adjustable exchange rates.

Under this system, countries committed to maintaining their currency value within 1% of the agreed exchange rates, intervening as necessary by buying or selling foreign reserves. One of the key goals was to promote economic stability and prevent the competitive devaluations that plagued the economy in the interwar period. The system also laid the groundwork for the establishment of the International Monetary Fund (IMF) and the World Bank, institutions that helped stabilize and develop global economies.

Currency Convertibility

Currency convertibility refers to the freedom to convert the domestic currency into other foreign currencies and vice versa, without central bank intervention or against limited controls. Under the gold standard, currencies were fully convertible into gold, giving individuals and countries alike the assurance of their currency's value.

Post-World War II, under the Bretton Woods system, only the U.S. dollar was truly convertible into gold, making its convertibility the linchpin of the global financial system. Full currency convertibility is advantageous for international trade and investment as it removes foreign exchange risk, but it also requires a country to have robust and reliable foreign exchange reserves to maintain the currency’s value.

Fixed Exchange Rate

Fixed exchange rate systems are those in which a country's currency value is tied or pegged to another major currency or basket of currencies. Both the gold standard and the Bretton Woods systems were examples of fixed exchange rate systems, though they operated differently.

With a fixed exchange rate, countries aim to maintain a stable foreign exchange rate, which helps provide certainty in international trade and investment. This system necessitates a government commitment to intervene in the foreign exchange market, buying or selling its currency as needed to maintain the pegged rate. While it can provide stability and predictability, it also means that countries might have to sacrifice some monetary policy autonomy, which can be a significant drawback if the national economic conditions diverge from those of the pegged currency’s country.