U.S. exchange rate policy: Bretton Woods to the present - includes glossary

Federal Reserve Bulletin, Nov, 1990 by B. Dianne Pauls

U.S. Exchange Rate Policy: Bretton Woods to Present

Over the past thirty years or so, the United States has operated under two distinct exchange rate regimes. The first, which lasted effectively from December 1958 to March 1973, was the Bretton Woods system of fixed exchange rates. In the second, which began in March 1973 and has continued to the present, exchange rates have been subject to managed floating. This article traces the evolution of U.S. exchange rate policy through these two regimes, focusing for each on the broad objectives of U.S. policy, operational objectives and approaches, and the major episodes in policy during the period.

The Bretton Woods System: December 1958 to March 1973

The system of fixed exchange rates was provided for in the Articles of Agreement, the charter for the International Monetary Fund that was negotiated at Bretton Woods, New Hampshire, in 1944. Although the Articles went into force in December 1945, the system of fixed exchange rates envisaged at Bretton Woods became fully operational only at the end of 1958, when most major foreign currencies became convertible for the private sector into dollars for current account transactions.(1) Under the Bretton Woods system, par values were established for the currencies of IMF member countries in terms of gold or the "U.S. dollar of specified gold content."(2) Foreign monetary authorities were obliged to intervene in foreign exchange markets to maintain the value of their currencies within 1 percent of their dollar parities. Monetary authorities in major foreign countries undertook this intervention in dollars; the U.S. Treasury stood ready to sell gold to them or buy it from them at the official price of $35 per ounce. In light of this commitment by the United States and the dominance of the U.S. economy, the dollar was the principal reserve currency and, aside from gold, the principal reserve asset of the Bretton Woods system. Sterling remained a reserve currency, but it was only a minor one for countries outside of the British Commonwealth.

Because the responsibility for intervention in exchange markets lay with foreign authorities, direct U.S. intervention during the Bretton Woods era was extremely limited. Before August 15, 1971, U.S. operations were restricted largely to two types: selling gold to foreign authorities for the dollars acquired by those authorities in exchange market intervention; and, later, buying dollars from foreign authorities in return for that country's currency, which the United States had acquired by drawings on the Federal Reserve swap network and the issuance of bonds denominated in foreign currencies. Only after the dollar had been declared inconvertible into gold, had been devalued in the Smithsonian Agreement, and still was under downward pressure in exchange markets, did U.S. authorities undertake much direct intervention in the exchange market.

Broad Objectives of U.S. Exchange Rate Policy

In establishing the Bretton Woods system, the IMF's Articles of Agreement heavily stressed exchange rate stability. The intent was to discourage the competitive devaluations that were viewed as contributing to economic and financial chaos in the 1920s and 1930s. The Articles formally permitted adjustment of a currency's par value only if the country's balance of payments was in "fundamental disequilibrium." This was an imprecise concept, but it came to mean that exchange rates would be adjusted only as a last resort and only in conjunction with other policies to redress the disequilibrium.

Given the widespread concern about competitive devaluations and the goal of maintaining a system of fixed exchange rates, the overriding objective of U.S. exchange rate policy was the maintenance of a fixed par value of the dollar. Keeping the dollar a leading standard and store of value provided a stable center for the world's monetary structure. Revaluations of foreign currencies against gold and the dollar, though few, were more readily accepted by the United States than devaluations, which were considered appropriate only if unavoidable. Devaluation of the dollar, under the Bretton Woods system, could be achieved only by an increase in the dollar price of gold without a commensurate increase in the price of gold in terms of other currencies. Hence, it could not be accomplished without the cooperation of foreign authorities. Moreover, most U.S. policymakers ruled out devaluation of the dollar: They saw it as likely to disturb the world economy by increasing the propensity to shift reserves out of dollars and into gold and thereby undermining confidence in the fixed exchange rate system.

Operational Objectives and Approaches

The credibility of the U.S. commitment to convert dollars into gold came into question in the early 1960s, when the United States began to cumulate deficits in its balance of payments. (See the glossary for a definition of this term and others used in this article.) From 1960 to 1967, as U.S. residents continued to invest in the reconstruction of Western Europe and Japan, large capital outflows generally outweighed surpluses in the U.S. trade and current accounts. Foreign monetary authorities began to accumulate dollars as they intervened to maintain the value of their currencies in the face of growing U.S. payments deficits. In turn, they purchased gold more and more from the U.S. Treasury with these dollars. The Treasury sold, net, more than $10 billion worth of gold between December 1958 and August 1971, cutting its gold stock in half (see chart 1). Sales to France and in the London gold market to stabilize the market price around the official price accounted for much of this total. Even if gold were not immediately demanded, there remained the threat that it could be demanded by foreign monetary authorities. To preserve the credibility of the offer to convert dollars into gold and, with it, the stability of the Bretton Woods system, the protection of the U.S. gold stock became the key operational objective of U.S. exchange rate policy. The government adopted five approaches to meeting this objective.