Chapter 27: Problem 924

Why did the United States have to devalue its dollar in 1971 and again in 1973 ?

Short Answer

Expert verified

The United States had to devalue its dollar in 1971 and 1973 primarily due to the collapse of the Bretton Woods system and the need to address its balance of payment and trade imbalance issues. The Bretton Woods system established fixed exchange rates, pegging other currencies to the US dollar and the dollar to gold. However, it faced challenges including the increasing US fiscal and trade deficits, a rising demand for gold, and the decrease in US economic strength. The 1971 devaluation, known as the Nixon Shock, involved suspending the convertibility of the US dollar into gold and implementing policies to reduce trade imbalances and curb inflation. The 1973 devaluation aimed to stimulate the economy and improve the balance of payments. These devaluations contributed to the decline of the US dollar's dominance and led to the era of floating exchange rates.

Step by step solution

Understanding the Bretton Woods System

The Bretton Woods system was established in 1944, creating a fixed exchange rate regime, where the value of each country's currency was pegged to the US dollar. The US dollar was in turn pegged to gold at a value of 35 dollars per ounce. This system aimed to promote international trade, economic growth, and stability following World War II.

Causes of the Collapse of the Bretton Woods System

Over time, the system began to face numerous challenges, including: 1. The increasing US balance of payment deficits, driven by its growing fiscal deficit and trade deficit. 2. The increasing amount of US dollars held outside the country, which led to a rising demand for gold. 3. Some major economies started to recover after World War II, leading to a decrease in the US's relative economic strength.

The 1971 Devaluation

In response to these challenges and pressures, President Richard Nixon took the following actions in August 1971, which was also known as the "Nixon Shock". 1. Suspended the convertibility of the US dollar into gold, effectively ending the Bretton Woods system. 2. Implemented a 10% surcharge on imports to reduce trade imbalance and protect domestic industries. 3. Imposed wage and price controls to curb inflation. As the Bretton Woods system collapsed, the US dollar was devalued to help address the balance of payment issues, as well as to reduce its trade deficit.

The 1973 Devaluation

In February 1973, the US devalued its dollar again, this time by 10%. This devaluation aimed to stimulate the economy by making exports cheaper and imports more expensive, thus improving its balance of payments position. This event marked the beginning of the era of floating exchange rates, as countries abandoned the fixed exchange rate regime and allowed their currencies to find their market value.

Implications of the Devaluations

Devaluing the US dollar had both short-term and long-term consequences: 1. Short-term: It improved the balance of payments position and encouraged export-led growth 2. Long-term: It contributed to the decline of the US dollar's dominance in the global financial system, and eventually led to the erosion of international monetary cooperation. In conclusion, the main reasons the United States had to devalue its dollar in 1971 and 1973 were the collapse of the Bretton Woods system and the need to address its balance of payment and trade imbalance issues. This marked a turning point in the global monetary system, leading to the era of floating exchange rates.