EC 60 Lecture 12 Fall 2024 The Bretton Woods System
EC 60: Lecture 12 The Post-War Financial System
Overview
Examination of the post-war financial system and the evolution from the Gold Standard to Bretton Woods.
Gold Standard 1850-1914
Fractional Reserve System: Banking system where banks hold a fraction of deposits as reserves.
Fixed Exchange Rate Regime: Currencies were rigidly pegged to gold.
Price-Specie Flow Mechanism: Economic theory explaining how trade balances adapt through gold flows.
Ended with the advent of WWI & a failed attempt to return in the interwar period.
Reason for Collapse: The gold standard emphasized external balance over internal economic stability, causing imbalances and crises.
The Mechanics of the Gold Standard
Example: Fractional Reserve System
Gold Backing: Currency backed by gold; Bank of England was pivotal.
Example Transactions:
Farmer A deposits £100.
Bank credits Lloyds’ reserve account with £100.
Lloyds loans Farmer C £900, creating £1000 in demand deposits.
Reserve Requirement: Set at 10% for banks, based on their deposits.
Fixed Gold Price: 1 £ pegged to an oz of gold, establishing a rigid currency value.
Price-Specie Flow Mechanism
Economic Adjustment: Differences in trade lead to gold flow between countries, impacting money supply and price levels.
Example:
France imports wine from England, causing gold to flow to England.
Adjusts English and French price levels, influencing trade balances.
John Maynard Keynes and the Gold Standard
Critique of the Gold Standard: Noted for creating cycles of inflation and recession.
Historical instances where the failures of the gold standard were highlighted:
Post-Napoleonic Wars England.
Post-Civil War United States.
Post-WWI England.
Historical Returns to the Gold Standard
Post-Napoleonic War
Britain resumed the gold standard at pre-war parity levels.
Inflation During War: Led to a rise in gold prices that caused economic contraction post-war.
Economic Consequence: Price drop of 40% by 1896 left farmers in distress.
The American Civil War Impact
Dual Currency Issue: Both gold and silver circulated; excessive printing of greenbacks led to inflation.
Post-War Return to Gold: Deflation occurred, impacting economic recovery adversely.
Britain's Post-WWI Experience
Conference in Genoa (1922) aimed to revive the gold standard.
Return at pre-war parity in 1925 led to economic stagnation due to strict deflation measures.
Economic Crises of the 1930s
Great Depression
Stock market crash led to bank failures and a 75% contraction of the money supply.
Britain suspended gold standard conversion in 1931.
The End of the Gold Standard
Competitiveness Shift: U.S. and other nations started to suspend gold conversions, altering exchange rates.
Policies involved raising the price of gold and altering currency values led to a more flexible monetary system.
Bretton Woods System: Establishing New Order
Formation of the IMF
Established in July 1944 by 44 countries during the Bretton Woods Conference.
Introduced concepts of adjustable pegs and a managed monetary system.
Keynes vs. White
Keynes' Proposal: An international currency managed by the IMF.
White's Proposal: U.S. dollar as the central reserve currency, pegged to gold.
Gold Exchange Standard
U.S. dollar pegged at $35/oz of gold.
International trade relied heavily on the dollar, linking global economies.
Mechanisms of Fixed Exchange Rate
National currencies functioned as banking reserves.
Exchange rates pegged, requiring monetary policy adjustments to maintain stability.
Challenges to Bretton Woods
Speculative Attacks in the 1960s
Persistent trade deficits raised concerns about currency stability.
Expectation of devaluation led to speculation against the pound, forcing Britain to devalue in 1967.
Collapse of Bretton Woods
U.S. policies in the late 1960s strained the system, causing inflation and trade deficits.
Change in Strategy: Adoption of a two-tier gold system and eventual float of currencies became necessary due to persistent imbalances.