Smithsonian Parities

Published Sep 8, 2024

### Smithsonian Parities

Definition of Smithsonian Parities

Smithsonian Parities refer to the exchange rate adjustments and economic policies set forth during the Smithsonian Agreement in December 1971. This agreement aimed to realign and stabilize the international monetary system after the collapse of the Bretton Woods system. The Smithsonian Agreement included a revaluation of the major currencies against the US dollar, a devaluation of the dollar itself, and the introduction of a wider band for currency fluctuations.

Background

Following World War II, the Bretton Woods system established fixed exchange rates, pegging world currencies to the US dollar, which was convertible to gold. However, by the late 1960s, this system faced severe strains due to persistent US balance of payments deficits and inflation. Confidence in the US dollar dwindled, and countries demanded gold in exchange for their dollar reserves, causing a drain on US gold reserves.

On August 15, 1971, US President Richard Nixon suspended the convertibility of the dollar into gold, effectively ending the Bretton Woods system. In the following months, negotiations took place to create a new system, culminating in the Smithsonian Agreement.

Details of the Smithsonian Agreement

The Smithsonian Agreement contained several key points:

1. Revaluation of Currencies: Major currencies like the Japanese yen and German mark were revalued upward against the US dollar, making their exports more expensive and imports cheaper. In contrast, the US dollar was devalued, set at $38 per ounce of gold instead of the previous $35.
2. Wider Fluctuation Bands: The agreement allowed currencies to fluctuate within a wider band of ±2.25% around the fixed parity compared to the previous ±1%. This aimed to provide more flexibility and reduce speculative pressures.
3. Intervention Policies: Countries agreed to intervene in the foreign exchange markets to maintain their currencies within the agreed bands. Central banks would buy or sell currencies as needed to uphold their parities.

Example

Consider the Japanese yen and the German mark as examples of currency adjustments under the Smithsonian Agreement:

• The yen was revalued from 360 yen per US dollar to approximately 308 yen per US dollar, making Japanese goods more expensive in the US and US goods cheaper in Japan. This adjustment aimed to address trade imbalances and alleviate the pressure on the dollar.
• The German mark was revalued from 3.66 marks per US dollar to about 3.22 marks per US dollar. Similar to the yen, this revaluation made German exports more costly and imports less expensive, aiming to correct trade disparities.

Why Smithsonian Parities Matter

The Smithsonian Parities were significant for several reasons:

1. Stabilization of Exchange Rates: The agreement temporarily stabilized exchange rates and restored confidence in the global monetary system, preventing a chaotic devaluation race and potential trade wars.
2. Precedent for Future Agreements: It set a precedent for future international monetary cooperation and frameworks for managing exchange rates and economic policies.
3. Step Toward Floating Rates: The failure of the Smithsonian Parities to endure laid the groundwork for the eventual adoption of floating exchange rates, which became the norm after the collapse of the agreement in 1973.

Frequently Asked Questions (FAQ)

Why did the Smithsonian Agreement fail to provide a long-term solution?

The Smithsonian Agreement was unable to offer a long-term solution due to its inability to address underlying economic imbalances and structural issues. Persistent US inflation, continued balance of payments deficits, and divergent economic policies among countries led to sustained pressures on the fixed exchange rates. Consequently, the system collapsed in 1973, giving way to floating exchange rates.

How did the shift from fixed to floating exchange rates impact global trade and investment?

The shift to floating exchange rates introduced greater flexibility in exchange rates, allowing them to adjust to market forces and economic conditions. This reduced the need for large foreign exchange reserves and frequent interventions by central banks. However, it also introduced higher volatility in exchange rates, impacting international trade and investment decisions. Firms and investors had to adopt new strategies to manage exchange rate risk, such as hedging through derivatives.

Are there any lessons learned from the Smithsonian Agreement relevant to today’s global economy?

The Smithsonian Agreement offers several lessons for today’s global economy. It underscores the importance of international cooperation and coordination in managing exchange rates and addressing economic imbalances. It also highlights the limitations of fixed exchange rate systems in the face of divergent economic policies and conditions. Policymakers can draw on these lessons when designing frameworks for exchange rate management and international monetary cooperation to ensure stability and accommodate the complexities of the modern global economy.