CHAPTER 20 The International Financial System 525 As long as countries abided by the rules under the gold standard and kept their currencies backed by and convertible into gold, exchange rates remained fixed However, adherence to the gold standard meant that a country had no control over its monetary policy because its money supply was determined by gold flows between countries Furthermore, monetary policy throughout the world was greatly influenced by the production of gold and gold discoveries When gold production was low in the 1870s and 1880s, the money supply throughout the world grew slowly and did not keep pace with the growth of the world economy The result was deflation (falling price levels) Gold discoveries in Alaska and South Africa in the 1890s greatly expanded gold production, causing money supplies to increase rapidly and price levels to rise (inflation) until World War I The Bretton Woods System After World War II, the victors set up a fixed exchange rate system that became known as the Bretton Woods system, after the New Hampshire town in which the agreement was negotiated in 1944 The Bretton Woods system was in effect until 1971 The Bretton Woods agreement created the International Monetary Fund (IMF), headquartered in Washington, D.C., which had 30 original member countries in 1945 and currently has 180 The IMF was given the task of promoting the growth of world trade by setting rules for the maintenance of fixed exchange rates and by making loans to countries that were experiencing balance-of-payments difficulties As part of its role of monitoring the compliance of member countries with its rules, the IMF also took on the job of collecting and standardizing international economic data The Bretton Woods agreement also set up the International Bank for Reconstruction and Development, commonly referred to as the World Bank, also headquartered in Washington, D.C., which provides long-term loans to help developing countries build dams, roads, and other physical capital that would contribute to their economic development The funds for these loans are obtained primarily by issuing World Bank bonds, which are sold in the capital markets of the developed countries In addition, the General Agreement on Tariffs and Trade (GATT), headquartered in Geneva, was set up to monitor rules for the conduct of trade between countries (tariffs and quotas) and the GATT has evolved into the World Trade Organization (WTO) Because the United States emerged from World War II as the world s largest economic power, with over half of the world s manufacturing capacity and the greater part of the world s gold, the Bretton Woods system of fixed exchange rates was based on the convertibility of U.S dollars into gold (for foreign governments and central banks only) at US$35 per ounce The fixed exchange rates were to be maintained by intervention in the foreign exchange market by central banks in countries besides the United States who bought and sold U.S dollar assets, which they held as international reserves The U.S dollar, which was used by other countries to denominate the assets that they held as international reserves, was called the reserve currency Thus an important feature of the Bretton Woods system was the establishment of the United States as the reserve currency country Even after the breakup of the Bretton Woods system, the U.S dollar has kept its position as the reserve currency in which most international financial transactions are conducted However, with the creation of the euro in 1999, the supremacy of the U.S dollar may be subject to a serious challenge (see the Global box, The Euro s Challenge to the U.S Dollar)