With the failure of gold standard during First World War, a much refined form of exchange regime was initiated in 1925 in which US and England could hold gold reserve and other nations could hold both gold and dollars/sterling as reserves. In 1931, England took its foot back which resulted in abolition of this regime.
Also to maintain trade competitiveness, the countries started devaluing their currencies in order to increase exports and demotivate imports. This practice led to great depression which was a threat to war ravaged world after the Second World War. Allied nations held a conference in New Hampshire, the outcome of which gave birth to two new institutions namely the International Monetary Fund (IMF) and the World Bank, (WB) and the system was known as Bretton Woods System which prevailed during (1946-1971) (Bretton Woods, the place in New Hampshire, where more than 40 nations met to hold a conference).
The Bretton Woods Era (1946 to 1971)
To streamline and revamp the war ravaged world economy & monetary system, allied powers held a conference in 'Bretton Woods', which gave birth to two super institutions - IMF and the WB. In Bretton Woods modified form of Gold Exchange Standard was set up with the following characteristics:
- One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce of Gold
- Other members agreed to fix the parities of their currencies vis-à-vis dollar with respect to permissible central parity with one per cent (± 1%) fluctuation on either side. In case of crossing the limits, the authorities were free hand to intervene to bring back the exchange rate within limits.
Purchasing Power parity
According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of prices between two countries. Since A has had a relatively greater rise in prices, A‘s currency depreciates, will fall, and a new exchange rate will get established.
The monetary theory states that there is a direct connection between relative changes in money supply in two countries and the exchange rate between both countries, provided there are no transportation costs in moving goods between both countries.
Floating rate system
A floating exchange rate occurs when governments allow the exchange rate to be determined by market forces and there is no attempt to influence the exchange rate. A floating exchange rate contrasts with a fixed exchange rate. A situation where the government try to keep the exchange rate within a certain target against other currencies.