International Monetary Fund organization

International Monetary Fund (IMF) An international organization that provides foreign currency loans to central banks and oversees the operation of the international monetary system.

 

Under the Bretton Woods system, central banks were committed to selling dollars in exchange for their own currencies. This commitment required them to hold dollar reserves. If a central bank ran out of dollar reserves, it could borrow them from the newly created IMF.

 

Under the Bretton Woods system, a fixed exchange rate was known as a par exchange rate. If the par exchange rate was not the same as the exchange rate that would have been determined in the market, the result would be a surplus or a shortage.

 

A persistent shortage or surplus of a currency under the Bretton Woods system was seen as evidence of a fundamental disequilibrium in a country’s exchange rate. After consulting with the IMF, countries in this position were allowed to adjust their exchange rates. In the early years of the Bretton Woods system, many countries found that their currencies were overvalued versus the dollar, meaning that their par exchange rates were too high.

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Figure 19A.1

A Fixed Exchange Rate above Equilibrium Results in a Surplus of Pounds

Under the Bretton Woods system, if the par exchange rate was above equilibrium, the result would be a surplus of domestic currency in the foreign exchange market. If the par exchange rate was below equilibrium, the result would be a shortage of domestic currency. In the figure, the par exchange rate between the pound and the dollar is $4 = £1, whereas the equilibrium exchange rate is $2.80 = £1. This gap forces the Bank of England to buy £1 million per day in exchange for dollars.

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Devaluation A reduction in a fixed exchange rate.

 

Revaluation An increase in a fixed exchange rate.

 

 

The Collapse of the Bretton Woods System

 

By the late 1960s, the Bretton Woods system faced two severe problems.

The first was that after 1963, the total number of dollars held by foreign central banks was larger than the gold reserves of the United States.

The second problem the Bretton Woods system faced was that some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies.

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Figure 19A.2


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