The managed floating rate system

Global commerce among nations can only be conducted by converting national currencies into other currencies, and these currency conversions take place at prevailing exchange rates. Obviously, global trade and finance can’t grow unless there is an efficient, established system for exchanging national currencies.

Historically, nations have experimented with financial systems based on fixed exchange rates as well as flexible rate systems. In July 1944, financial officials from 45 countries met at the resort town of Bretton Woods, N.H. to establish a global financial system that would promote expanded world trade and finance.

The Bretton Woods conference created a multilateral institution known as the International Monetary Fund that would oversee a monetary system based on fixed exchange rates with global currencies pegged to the dollar, which was tied to the price of gold. The Bretton Woods system of fixed exchange rates fostered global economic prosperity in the early post-WWII decades, but the unduly rigid system collapsed in the early 70s, and a more flexible exchange rate system took its place.

The current global monetary system is most accurately described as a “managed floating rate” system, because currency values are allowed to change freely, but central banks periodically intervene to correct disorderly market conditions and prevent excessive rate fluctuations.

To facilitate such intervention activity, central banks maintain a supply of reserve currencies. The vast majority of reserve currency holdings consist of dollars, but global monetary authorities also hold (relatively) small amounts of Japanese yen, British pounds, and Euros.