The economic world never remains the same — there are changes, and the financial revelations keep coming consistently. One such series of economic measures was the Nixon shock.
Please read below to find out about the Nixon shock and the circumstances that lead to it.
Bretton Woods Agreement
Since the Second World War, the United States became the world’s global superpower. As per the Bretton Woods Agreement of 1944, major currencies of all the Western world were designated a fixed exchange rate with the USD. It was recognized as the currency pegging to the U.S. dollar. All member states committed to holding the average exchange rate of their currency within such a band plus or minus 1% of the pegged limit. Attendees would participate in foreign exchange markets by purchasing or selling their currencies to preserve the value of its currency inside the band decided above. The demand and supply mechanism will then return the currency to the accepted level.
The Bretton Woods Treaty pretty much made the U.S. dollar the reserve currency of the Western world. The U.S. dollar grounded currencies all over the globe. The United States decided simultaneously to attach the dollar to gold at $35 an ounce. Foreign countries could interchange dollars for gold if they truly wish. The goal of this arrangement was to raise trust in the dollar further.
Changing Economic Climate
Regrettably, the world economic condition started to shift in the 1960s. Presidents Kennedy and Johnson had already tried to deal with the exchange-rate difficulties via several actions built to assist the dollar. Sadly, these steps were not completely effective. By 1971, the U.S. had funded a massive land and air battle in Vietnam; sales had soared, and inflation was nearly 6% annually. More U.S. currency was required for foreign trading, and the availability of money decreased. The U.S. was operating a massive trading imbalance, so dollars began to float overseas. Foreign exchange merchants feared the depreciation of the U.S. currency was inevitable. As a consequence, they gradually sold dollars and forced the currency to run occasionally.
What was the Nixon Shock?
The Nixon Shock was a sequence of financial actions taken by U.S. President Richard Nixon in 1971 due to higher inflation. The most important of which were salary and cost freezes, import surcharges, and unilateral cancellation of the international routes fixed exchange rates of the U.S. dollar to gold.
Although Nixon’s acts did not officially dismantle the current Bretton Woods network of foreign financial markets, the removal of one of its main elements mostly made the Bretton Woods framework inoperative. While Nixon openly declared his willingness to continue the direct conversion of the dollar after the initiatives of the Bretton Woods were implemented, all efforts at reform were ineffective. By 1973, the Bretton Woods structure was de facto replaced by the new framework based on openly floating fiat currencies.
Meltzer, A. (1991). Files.stlouisfed.org. Retrieved 29 May 2020, from https://files.stlouisfed.org/files/htdocs/publications/review/91/05/Bretton_May_Jun1991.pdf.
Irwin, D. (2012). The Nixon Shock after Forty Years: The Import Surcharge Revisited, 12, 26–59. Retrieved 29 May 2020, from https://www.nber.org/papers/w17749.