A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign exchange reserves. These reserve currencies usually become the international pricing mechanisms for commodities traded on the global market such as oil, natural gas, gold, and silver, causing other countries to hold this currency to pay for these goods. Currently, the U.S. dollar is the primary reserve currency in the world, kept not only by American banks but by other countries.
Reserves act as a shock absorber against factors that can negatively affect a currency's exchange rate, so a nation's central bank uses its currency reserves to help maintain a steady rate, buying or selling depending on which direction they want exchange prices to go. Manipulating and adjusting the reserve levels can enable a central bank to prevent volatile fluctuations in currency by affecting the exchange rate and increasing the demand for and value of the country's own currency.
Periodically, the board of governors of a central bank meets and decides on the reserve requirements as a part of monetary policy. The amount that a bank is required to hold in reserve fluctuates depending on the state of the economy and what the governing board determines as the optimal level.
Examples of Reserve Currencies
In the past, reserve currencies have come about in a de facto manner: They simply were the currency that belonged to the most powerful nations or the ones that dominated trade. The Bretton Woods Agreement (see below) essentially appointed the U.S. dollar as the world's leading currency reserve in 1944. But there are other popular currencies held in reserves.
The closest thing to an official list of reserve currencies comes from the International Monetary Fund (IMF), whose special drawing rights (SDR) basket determines currencies that countries can receive as part of IMF loans. The euro, introduced in 1999, is the second most commonly held reserve currency. Others in the basket include the Japanese yen and the British pound sterling. The latest addition, introduced in October 2016, is China's yuan or renminbi.
The U.S. Currency Reserve System
In the U.S., almost all banks are part of the Federal Reserve system and it is required that a certain percentage of their assets be deposited with their regional Federal Reserve Bank.
These reserve requirements are established by the Fed's Board of Governors. By varying the requirements, the Fed is able to influence the money supply. Reserves also keep the banks secure by reducing the risk that they will default by ensuring that they maintain a minimum amount of physical funds in their reserves. This increases investor confidence and stabilizes the economy.
The Dollar as the World's Reserve Currency
In 1944, during World War II, 44 nations met and decided to link their currencies to the U.S. dollar, the U.S. being the strongest power among the Allies. As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency, backed by the world’s largest gold reserves. Instead of keeping supplies of gold, other countries accumulated reserves of U.S. dollars; central banks would maintain fixed exchange rates between their currencies and the greenback. After the war ended, the restructured governments of the former Axis powers also agreed to use dollars for their currency reserves.
The U.S. dollar went off the gold standard in the 1970s, leading to contemporary floating exchange rates. But it remains the world’s reserve currency, and the most redeemable currency for global commerce and transactions, based largely on the size and strength of the U.S. economy and the dominance of the U.S. financial markets.