Reserve Currency - Explained

What is the Reserve Currency?

Updated at March 29th, 2023

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What is a Reserve Currency?

Many central banks of countries in the world hold large quantities of reserve currency. A reserve currency refers to a strong currency, often a foreign currency used for international trade and to settle international debts and obligations. Large financial institutions also hold a significant quantity of reserve currency for investment purpose. Aside from foreign currency, a countrys reserve currency can also be made of gold and oil which are used for international transactions.

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How does a Reserve Currency Work?

Reserve currency is used in the global economy, countries hold large reserve currency through central banks in order to influence domestic exchange rate and mitigate exchange rate risks while transacting with other countries. Many countries have been holding the U.S dollar has their primary reserve currency as far back as 1944. In addition to the U.S dollar, some countries hold gold and oil in their reserve currency. Reserve currency is an important concept in international trade, countries use the amount in the reserve currency to settle international obligations and make trades.

How the U.S. Dollar Became the Worlds Reserve Currency

The U.S dollar occupies the position of the worlds reserve money, hence countries monitor the monetary policy in the U.S to guarantee to safety of their reserves as well as guide against inflationary effects. The U.S dollar became the worlds reserve currency in 1944, this was as a result of the Bretton Woods Agreement in which 44 countries adopted the U.S dollar as the worlds reserve currency. This agreement followed the significant position held by the United States in international trade. As at this time, the U.S GDP represented 50% of the entire GDPs in the world. Considering the stability of the U.S dollar, it was adopted as the official reserve currency so that it would aid the stability of other currencies. This agreement signed in 1944 have a favorable effect on other currencies of the world. Also, at this tie, the dollar was gold-backed through foreign investments but this did not last for long. The U.S government printed more dollars that were no longer backed by gold but by its Treasury debt. The more dollars the U.S printed, the lesser the influence of gold.

The Gold/Dollar Decoupling

The gold-dollar decoupling through the approach of the U.S government towards reducing the significance of gold reserves. This was predominantly done through printing or more U.S dollars that were backed by its Treasury debts and not the gold reserve. The U.S flooded both the domestic and international markets with dollars and this diminished the value of the gold reserve currency. The U.S as at this time printed more paper dollars which was used to finance the Great Society programs and the Vietnam war, this led to the response of dollar reserves being converted into gold. President Nixon also contributed to the decoupling of gold and dollar and this also led to the emergence of floating exchange rates.

Continued Faith in the U.S. Dollar

The U.S dollar holds an indisputable significant position in the world's reserve currency. Countries have accumulated much of the U.S dollars over time to the extent that it has remained the worlds currency reserve. The global economy and the international markets have expressed so much faith the U.S dollar which makes it the most liquid and stable exchange in international trade. The U.S dollar is backed by the U.S treasuries.

Reserve Currencies Today

According to a 2010 report released by the United Nations Conference on Trade and Development, there is a recommendation that a global currency be created to replace the U.S dollar as the worlds reserve currency. This suggestion is based on the opinion that the U.S dollar has become unstable in terms of its value in the global market. Despite this suggestion, the U.S dollar has remained the worlds reserve currency. The second most held currency in the global economy is the euro which was introduced in 1999. Also, in October 2016, the China's renminbi (RMB) was declared an official reserve currency by the International Monetary Fund (IMF).

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