Lesson 1 of 11
Until 1914, bank notes represented gold held by governments. The pound sterling, for example, was officially linked to a given amount of gold, which the Bank of England promised to pay, if so requested. Many other countries also adopted the gold standard in the 1880’s so that the value of their currencies was fixed against a common standard, gold. The money supply and government spending in each country were restricted by the amount of gold in the country’s official reserves. Currency stability helped the development of international trade during this period.
The gold standard was suspended in 1914, with the outbreak of the Great War. When the war ended, only the United States could afford to return to the gold standard. The economic depression in the 1930’s caused the final collapse of the system.
The gold standard was also reintroduced in the UK, but abandoned in 1932.
Towards the end of the 1939-1945 World War, concerted international efforts were made to rebuild the global economy. As the world’s strongest economy; the United States played the leading role.
One product of the international co-operation was the Bretton Woods Agreement of 1944, named after the town in New Hampshire where the agreement was made. This marked a return to a fixed rate regime. Under the terms of the agreement:
The US dollar’s value against the gold was fixed (at $35 an ounce) and the US government undertook to buy or sell gold in exchange for dollars at this fixed rate.
Each member country set a parity value for its currency against the US dollar and gold, and undertook to use central bank intervention to maintain the exchange rate within 1% of its parity.
In effect the world’s economies had returned to a gold standard to a US dollar acting as the major reserve currency (i.e. currency held in the official reserves of the other countries) as well as the world’s major trading currency. Other governments could hold US Dollars as official reserves with the reassurance that if they wanted to exchange the dollars for gold, the US government would do this for them, at the fixed rate of $35 an ounce.
From time to time, the exchange rate of a major currency had to be devalued against the US dollar (and so against all other traded currencies). However, the Bretton Woods system functioned reasonably well until the late 1960’s but it was clearly dependent for its continuing effectiveness on the stability of the US dollar’s value.
In the early 1970s the growing US trade and budget deficits, due largely to the Vietnam war and the cost of space exploration, combined with the sudden increase in the world price of oil, led to the final breakdown of the system. The US government suspended the convertibility of the US dollar into gold in 1971.