Monetary exchange rate plays an important role in international trade. Different countries have different currency and to make an exchange of the same in terms of global trade is a challenging task. This currency exchange rate keeps on fluctuating on basis of various factors which affects its volatility. Countries develop different monetary policy as per the economic environment prevailing in their respective country. This monetary policy depends on various factors such as inflation or deflation rate, purchasing power of the currency, recessions, economic stability etc and exchange rate plays an important role in all these factors.
International exchange rate has gone through various changes right from its vey inception in the year 1870 of the Classical Gold Standard System to the present operating Floating Exchange Rate System. To understand The Bretton Woods System it is important to evaluate and understand the reason for the creation of the system, its salient features and reason for its abolishment. The same has been discussed as underRequirement of an international exchange rate can be traced back to the year 1870 when the world economy saw the enactment of the Traditional Gold Standard.
It was during the Gold Standard that paper currency of a country got its value in real terms. The Gold Standard implied that any nation adapting to the international exchange rate has to follow the rules laid down in the Gold Standard. As per Gold Standard, any person holding a currency of the country could exchange the same with the gold reserve that the country possessed or vice-versa (Cohen, 2002). Thus, a countries currency was equally backed by par value of gold reserves that the country possessed.
In no circumstances could the country inflict new currency without backing the same with gold reserves of the country. Thus the standard provided long term stability to the countries and was so designed that it could adhere and response to shocks in the economy and move towards maintaining an equilibrium in the economy. Gold Standard thus was a huge achievement in itself and maintained equilibrium for some time in the economy. However, it showing signs of loopholes and soon became a global concern since with more and more development in the global economy, countries felt the shortage of paper currency and found its gold reserves restrictive to inflict new currency as in no circumstances could the country introduce new currency without a par value of gold (Rajan & Subramanian, 2004).
Even most powerful countries like Great Britain realized the shortage of currency during the period of Great Depression and the trend was soon followed in other countries of the world. The situation worsened during the World War-1 as there was huge requirement of funds to buy war equipment’s and for social programs and welfare.
Further The Federal Bank kept rising its interest rate to make dollar the most powerful currency in the world which was followed by huge Recessions all around the world. It was finally decided by the countries together to abolish the Gold Standard (Frankel, 2005). With The Great Britain abolishing The Traditional Gold Standard in 1914, the period between 1918 to1939 which is regarded as the Interwar Period saw many ups and downs as different countries which had abandoned the Gold Standard from their country again reverted back to the Gold Standard at different interval of time.
Powerful countries like United States soon reverted back to the Gold Standard followed by The Great Britain in the year 1925 (Bordo and Eichengreen, 2008). However The Great Britain once again shifted from the Gold Standard in the year 1931 due to economic instability it faced after the World War and during the period OF Great Depression. Even United States followed Great Britain and abolished Gold Standard in 1933 but soon again reverted back to the same in 1934 with a standard rate of $35 per ounce of gold.
It was the post war consequences in the economy and huge deficit in the Balance of Payment with international liquidity crunch that the Gold Standard finally came to a complete end and it lead to the development of a new system of Bretton Woods (Roubini, 2004).