Just a look back at policy progression:
The Dollar Debacle
May 1995
Volume 13, Number 5
The Dollar Debacle
Jeffrey Herbener
The events of March 1995 could be a watershed in international monetary affairs. Beginning with the Bretton Woods agreement 50 years ago, the Federal Reserve system has been the global monetary regulator. The collapse of the dollar is a no-confidence vote that may have brought this role to an end.
In a system of freely-floating fiat paper currencies, each currency has a foreign exchange value determined by the "law of one price." This law states that the price of any good must be the same in every location, net of transportation costs. If this uniformity does not exist, arbitragers can make profits by buying where it is cheap and selling where it is dear.
When applied to currencies, this law is called the purchasing-power-parity (PPP) theory. Let's say 100 dollars buys more goods in Germany when exchanged for marks than it does in the United States. Then currency traders eliminate arbitrage profit by exchanging dollars for marks. They will do this until the dollar is devalued enough to bring the currencies in line. That's why some currencies appreciate or depreciate against others.
Can central bank interventions prevent these changes? Not at all. They don't eliminate market forces; they dam them up. Consider a case where PPP requires a devaluation of the dollar vis-a-vis the mark. The Fed intervenes to halt it by buying--or, better yet, pressuring the Bundesbank to buy--dollars that arbitragers are supplying in exchange for marks.
Since this intervention does nothing to relieve the underlying disparity, it does not stop the arbitraging. Furthermore, intervention not only requires intervening central banks to have large stocks of foreign currencies, but it imposes on them huge arbitrage losses at the point when the intervention is overwhelmed by market forces and traders devalue the dollar.
Central bank buying of dollars with marks cannot continue indefinitely. The purchasing-power disparity can be fixed by an exchange-rate fluctuation. Or it can be fixed by reducing the money stock of dollars relative to the money stock of marks. To do this, the Fed can reduce its inflation of the dollar or it can induce the Bundesbank to increase its inflation of the mark.
If the Fed has domestic policy reasons for wanting to continue inflating the dollar, then it must become embroiled in international tussles. Its cajoling and threatening work much better when backed up by military superpower status.
After World War I, Britain employed these tools to prevent a devaluation of the pound. The Bank of England had inflated the pound much more than the Fed had inflated the dollar during the war. Instead of allowing the pound to devalue (by redefining the pound in terms of the dollar and thus, reducing its gold content), the Bank of England convinced the Fed to inflate the dollar.
Unfortunately for the British, this merely emboldened the Bank of England to continue its rapid inflation and to press for the Fed to inflate even more. Great Britain lost its international preeminence in no small part because of its monetary policy and the programs it funded. The Bank of England can no longer cajole or threaten the Fed.
Bretton Woods was the changing of the guard in international monetary affairs. Since then the Fed has been in the preeminent position and the dollar has served as the world's reserve currency. But in the 1960s Fed inflation was called upon to fund a growing welfare-warfare state. As monetary inflation accelerated into the early 1970s, the United States faced a test of its monetary leadership. Countries with less inflationary currencies, especially France, began to ask the U.S. to exchange the dollar (now devalued) for gold at the rate agreed to at Bretton Woods: $35 per ounce.
Unwilling to slow Fed inflation and unable to accelerate inflation in other countries, President Nixon "closed the gold window" and devalued the dollar to $42.22 per ounce. This event marked the beginning of the decline in American economic strength. The 1970s was the worst decade of American economic performance since the Great Depression, which was also the product of Fed inflation...cont'd
http://www.mises.org/freemarket_detail.asp?control=245&sortorder=articledate 
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