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Why does the World use the dollar Currency as their main trading currency? Origins of a Unified Money System. The Bretton Woods system of money management established the rules for commercial and financial relations among the world's major industrial states in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to control monetary relations among independent nation-states. 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference. They were preparing to rebuild the international economic system as World War II was still being fought. The delegates deliberated during 1–22 July 1944, and signed the Agreement on its final day. Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF to bridge temporary imbalances of payments. Nations used the gold standard from the 1880’s to 1931. When a nation imported goods, their money would be out in the international sphere, making it worth less. They would have to slow imports and people would purchase goods from them (their goods would be cheaper) and the gold standard system was supposed to self-regulate. For several reasons, America acquired more gold than all of the rest of the world combined in the 1920’s. This imbalance led to the Great Depression and the end of the gold standard. Free trade relied on the free convertibility of currencies (exchange one currency for another, or for gold). Negotiators at the Bretton Woods conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade. The new economic system required an accepted vehicle for investment, trade, and payments. Unlike national economies, however, the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard, but the architects of Bretton Woods did not consider this option feasible for the postwar political economy. Instead, they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U.S. dollar (which was a currency backed by gold, for central banks) as a reserve currency. (All other currencies tied their money value to that of the US dollar) 1 Why did we go off of the Gold Standard and why do we have so much inflation? On 15 August 1971, the United States unilaterally terminated convertibility of the dollar to gold. This brought the Bretton Woods system to an end and saw the dollar become fiat currency. This action, referred to as the Nixon shock, created the situation in which the United States dollar became a reserve currency used by many states. At the same time, many fixed currencies (such as the British Pound, for example), also became free floating. By the early 1970s, as the costs of the Vietnam War, the Cold War and increased domestic spending on the Great Society accelerated inflation,[3] the U.S. was running a balance-of-payments deficit and a trade deficit. By 1971, America's gold stock had fallen to $10 billion, half its 1960 level. Foreign banks held many more dollars than the U.S. held gold, leaving the U.S. vulnerable to a run on its gold. At the time, the U.S. also had unemployment and inflation rates of 6.1% and 5.84% respectively. To prevent a run on the dollar, stabilize the economy, and decrease unemployment and inflation rates, on August 15, 1971, Nixon issued Executive Order 11615, pursuant to the Economic Stabilization Act of 1970, which imposed a 90-day maximum wage and price ceiling, a 10% import surcharge, and, most importantly, "closed the gold window", ending convertibility between U.S. dollars and gold. Later ramifications The Nixon Shock has been widely considered to be a political success, but an economic nightmare, in bringing on the stagflation of the 1970s and leading to the instability of floating currencies. The dollar value plunged by a third during the '70s, and in 1997 several Asian and Latin countries faced currency crises. Even to the present, Paul Volcker regrets the abandonment of Bretton Woods. "Nobody's in charge," Volcker says. "The Europeans couldn't live with the uncertainty and made their own currency and now that's in trouble." In 1996, Paul Krugman summarized the post-Nixon Shock era as follows: The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987—which started out every bit as frightening as that of 1929—did not cause a slump in the real economy. While a free-floating national money has advantages, it also has risks. For one thing, it can create uncertainties for international traders and investors. 2 Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible—and, in some countries, they have been quick to take the opportunity. Debate over the Nixon Shock has persisted to the present day, with economists and politicians across the political spectrum trying to make sense of the Nixon Shock and its impact on monetary policy in the light of the recent financial crises. Conservative columnist David Frum sums up the situation this way: The modern currency float has its problems. There is no magical monetary cure, monetary policy is a policy area almost uniquely crowded with trade-offs and lesser evils. If you want a classical gold standard, you get chronic deflation punctuated by depressions, as the U.S. did between 1873 and 1934. If you want a regime of managed currencies tethered to gold, you get regulations and controls, as the U.S. got from 1934 through 1971. If you let the currency float, you get chronic inflation punctuated by bubbles, the American lot since 1971. System 1 is incompatible with democracy, because voters won’t accept the pain inherent in a gold standard and vote out politicians even though it might not be their fault. System 2 is incompatible with the free market economics I favor because it has controls inconsistent with a free market. That leaves me with System 3 as the worst option except for all the others. Sources: Wikipedia, Cliffs Quick Review of Economics, http://fraser.stlouisfed.org/publication/?pid=430 Kannapel, Charles: Ramifications of the Nixon Shock, 2016 3