What is a 'Reserve Currency'
Reserve currency is currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate. A large percentage of commodities, such as gold and oil, are priced in the reserve currency, causing other countries to hold this currency to pay for these goods.
BREAKING DOWN 'Reserve Currency'Holding currency reserves minimizes exchange rate risk, as the purchasing nation will not have to exchange their currency for the current reserve currency in order to make the purchase. Since 1944, the U.S. dollar has been the primary reserve currency used by other countries. As a result, foreign nations closely monitored the monetary policy of the United States in order to ensure that the value of their reserves is not adversely affected by inflation.
How the U.S. Dollar Became the World’s Reserve Currency
The post-war emergence of the U.S. as the predominant economic power had enormous implications for the global economy. At one time, its GDP represented 50% of the world’s output, so it was a matter of course that the U.S dollar would become the global currency reserve, as it did in 1944. Since then, other countries pegged their exchange rates to the dollar, which was convertible to gold at the time. Because the gold-backed dollar was relatively stable, it enabled other countries to stabilize their currencies.
In the beginning, the world benefited from a strong and stable dollar, and the United States prospered from the favorable rate of exchange on its currency. What the foreign governments did not fully realize was that, although their currency reserves were backed by gold reserves, the United States could continue to print dollars that were backed by its Treasury debt. As the United States printed more money to finance its spending, the gold backing behind the dollars diminished. The continued printing of money beyond the backing of gold reserves reduced the value of the currency reserves held by foreign countries.
The Gold/Dollar Decoupling
As the United States continued to flood the markets with paper dollars to finance its escalating war in Vietnam and the Great Society programs, the world grew cautious and began to convert dollar reserves into gold. The run on gold was so extensive that President Nixon was compelled to step in and decouple the dollar from the gold standard, which gave way to the floating exchange rates we see today. Soon after, the value of gold tripled, and the dollar began its decades-long decline.
Continued Faith in the Dollar
Regardless, the U.S. dollar remains the world’s currency reserve, due primarily to the fact that countries had accumulated so much of it, and that it was still the most stable and liquid form of exchange. Backed by the safest of all paper assets, U.S. Treasuries, the dollar is still the most redeemable currency for facilitating world commerce.