Although there is no world currency, there are reserve currencies that are used in various financial transactions by central banks, corporations, and governments. Since World War II, the dominant reserve currency of the world has been the U.S. dollar. The dollar is a reserve currency since the U.S. economy, and its financial system is stable. For example, emerging market economies often have their debt denominated in U.S. dollars instead of their local currency.

Key Takeaways

  • There is no world currency, but there are reserve currencies that are used in transactions by central banks, corporations, and governments.
  • The U.S. dollar is the world's most widely used reserve currency since the U.S. economy, and its financial system is stable.
  • More than 60% of the central bank currency reserves are held in dollars, and many commodities are priced in dollars.

Understanding Global Currencies and Gold

At one time, all currencies were backed by gold, meaning that every country had to hold in reserve enough gold for all of the currency in circulation. In other words, gold was the standard by which all currencies were measured. After World War II, the United States became the world's largest and most dominant economy.

Due to the global expansion that took place after the war, bank reserves did not hold enough gold reserves to back the growth of the currency, which was needed to finance the global expansion. Consequently, the U.S. disconnected from the gold standard and began to print more paper money to finance the world's growth requirements. Because the U.S. was such a powerful economy, other countries agreed to accept the dollar as legitimate tender and followed suit to waiver the gold standard. Thus, the dollar became the most dominant currency.

Dollar as the De Facto World Currency

More than 60% of the central bank currency reserves are held in dollars. Central banks hold reserves to facilitate trade and financial transactions. The euro (the common currency of many European member states) is the next most widely-held currency, and it comprises of 20% of global reserves.

Many commodities are priced in dollars since the dollar provides a stable medium of exchange between international companies. Dollar-denominated commodities include the following:

More than 85% of the world's foreign exchange transactions are done in dollars. Forex transactions involve currencies being converted or exchanged into other currencies as a result of investing, global trade such as exports and imports as well as financial transactions from corporations.

Other Reserve Currencies

Over the years, other economies have developed, and so has the value of their currencies. Today, two other major reserve currencies are the euro and the Japanese yen (JPY).

While the U.S. dollar remains the reserve currency of the world, the world can be divided into three main currency blocks, with the Americas dealing mostly in dollars, Europe dealing in euros, and the Asian countries becoming more connected to the yen. China's economy is on the rise, and so is the Chinese yuan, but there remain obstacles to the yuan becoming a major reserve currency. China has implemented capital controls, for example, which prevent Chinese investors from transferring their yuan out of the country. Conversely, the yen, euro, and dollar are freely traded with no restrictions. Until China can remove its restrictions on capital flows, it'll be unlikely that the yuan will replace the dollar as the world's reserve currency.

Less dominant countries, such as Australia, once had to do business with the U.S. before finishing the transaction with Japan. In other words, Australian dollars (AUD) were first converted into U.S. dollars and then from U.S. dollars into Japanese yen. Today, there are many cross currencies, or instances when a currency pair is not associated with the U.S. dollar, allowing Australia to transact directly with Japan using AUD/JPY.