Foreign Currency Exchange & Risk Research Paper Starter

Foreign Currency Exchange & Risk

(Research Starters)

This article focuses on the rise and fall of the Bretton Woods (agreement) system. There will be a discussion of the role of the US dollar during this period as well as the role of the International Monetary Fund. The article will conclude with an explanation of how the Bretton Woods system ties into the study of International Political Economy.

Keywords Berlin Wall; Bretton Woods (agreements) system; Capitalism; Cold War; International Monetary Fund (IMF); International Political Economy; Liberalism; Marxism; Mercantilism; World Bank

Finance: Foreign Currency Exchange


Bretton Woods System

It was at the 1944 Bretton Woods International conference that a system of fixed exchange rates was adopted. In addition, the International Monetary Fund was established and charged with maintaining stable exchange rates at the international level. The Bretton Woods (agreement) system was concerned with developing and implementing the rules and regulations for global commercial and financial transactions. The International Bank for Reconstruction and Development (now known as the World Bank) was established as a result. This was the first effort to create a system that would control monetary dealings between independent nation-states. The greatest accomplishments of the Bretton Woods (agreement) system occurred when each country agreed to implement a financial policy that would maintain the exchange rate of its currency as a fixed market price in terms of gold. The International Monetary Fund had the ability to create connections between momentary imbalances of payments. Unfortunately, the arrangement disintegrated in 1971 as a result of the United States' suspension of convertibility from dollars to gold. The system was dismissed, and in its place, a method of floating exchange rates was initiated.

When there is a reference to the Bretton Woods system, most are referring to the international monetary regime that existed between the 1940s and the early 1970s. This system set precedent. It was the first attempt at a "fully negotiated monetary order intended to govern currency relations among sovereign states. This regime was designed to combine binding legal obligations with multilateral decision-making conducted through an international organization, the IMF, endowed with limited supranational authority" (Cohen, n.d., par. 1). The approach was built on constant and changeable exchange rates. Three of the most significant points of the agreement were:

  • When a country signed the agreement, it was agreeing to submit their exchange rate to international disciplines, which implied that the country would surrender its national sovereignty to a global corporation.
  • A nation wasn’t required to deflate the domestic economy when it faced chronic BP deficits.
  • The dollar was the standard to which all other currencies were pegged. However, it should be noted that the United States “did not have the authority to set the exchange rate between the dollar and any other currency” (The Bretton Woods System, n.d., ¶ 4).

The Role of the US Dollar

As mentioned in the third point mentioned above, the dollar became the dominant currency. In the 1950s, the United States became the foremost reserve nation, and the dollar replaced the worth of gold as a crucial and prominent global reserve advantage. However, it should be noted that this development was not planned; “all of the non-Communist countries maintained a stable relationship between their currencies and the dollar through the British pound; and the United States balance of payments was more important than those of other countries because other countries were holding the US dollar as the principal reserve asset” (The Bretton Woods System, n.d., “The Role of the US Dollar”).

During this period, the United States “was the dominant world power. As a result, over half of the international money transactions were financed in terms of the dollar. In addition, the United States produced more than half of the world output and owned about one third of the gold in the world. As the Bretton Woods system evolved, the reserves of most countries became a mixture of gold and dollars. Therefore, the US dollar became increasingly more important. Unfortunately, the United States was unable to eliminate increasing trade deficits, which eventually undermined the Bretton Woods system” (The Bretton Woods System, n.d., “The Role of the US Dollar”).


International Monetary Fund

The establishment of the International Monetary Fund (IMF) and the World Bank is probably one of the most important success stories for international economic cooperation. During the last sixty years, there have been many changes in terms of the political and economic climate on a global level, which have caused the world's top international financial institutions to shift in terms of how they operate their businesses. Given the number of financial crises that have surfaced during the last ten years, many scholars and practitioners in the field have called for a reform in how the international financial system is structured. These crises have exposed the weaknesses of the international financial system and highlight the fact that globalization has pros (benefits) and cons (risks).

Goals of the IMF

“The IMF was established to provide member countries with the necessary funds to cover short-term balance of payments problems. The Fund in turn received resources from members who were allotted quotas. Once a country enters the Fund, it receives a par value of its currency expressed in terms of gold or in terms of the US dollar using the weight of gold in effect on July 1, 1944 ($35 per troy oz). All exchange transactions between member countries were to be effected at a rate that diverged not more than 1% (which approximates gold import/export points) from the par values of the respective currencies” (The Bretton Woods System, n.d., “Contents of the Articles of Agreement”).

The IMF continues to diligently work at providing continuous improvement in practices that affect many sectors. For example, this body continues to:

  • Encourage members to provide public press releases that would detail the IMF Executive Board's evaluation of a nation's finances and policies.
  • Encourage members to provide information about the policies in place regarding the following and restoring of financial stability under the IMF regime.
  • Help countries implement guidelines, such as the Reports on the Observance of Standards and Codes, that will evaluate a nation’s development in practicing globally accepted standards.
  • Address gaps in regulatory standards through the Basle Committee on Banking Supervision.
  • Encourage members to put procedures in place when they are not experiencing any problems so that they are not responding to a crisis. It's an opportunity to be proactive versus reactive.
  • Help countries evaluate their obvious weaknesses and decide which exchange rate program is most appropriate for their needs.


International Political Economy (IPE)

Many IPE researchers have highlighted the significance of the relationship between economic and political factors with regard to international relations. IPE scholars are interested in the Bretton Woods system because of its significance in providing the foundation for the development of formal regime theory. The Bretton Woods system was a well designed regime that was negotiated and a part of the IMF. "The circumstances of the system's birth and life cycle offered scholars invaluable material for assessing the relative importance of diverse variables in promoting or inhibiting economic cooperation among governments"(Bretton Wood System, p. 10). The Bretton Woods system demonstrated that a social order could be durable at the international level. This factor provides the significance of the system to the IPE theory.

Influence of Political Factors on Economics

Many IPE scholars will argue that the international economic system and the international political system work in unison. Economic partnerships are determined by political and diplomatic relationships and vice-a-versa. According to Spero (1990), political factors affect economic outcomes in three ways, and they are:

  • The political system shapes the economic system because the structure and operation of the economic system is determined by the structure and operation of the international political system. One could see the influence of the international political system on the international economic system by reviewing the political developments during three periods of time in history. The three periods are nineteenth-century imperialism, the post-World War II era of cold war between the Soviet Union and the Western free world led by the United States, and the post-Berlin Wall demolition and the demise of the Soviet Empire era (Phatak, Bhagat, & Kashlak, 2005).
  • Period 1: Nineteenth-century imperialism and mercantilism were driven by two major political factors: The powerful nation-states in Europe (i.e. the United Kingdom, France, Germany and Holland) who had equal military power, and; nationalism practiced by these nation-states. These countries encouraged their citizens to practice and...

(The entire section is 4230 words.)