WHAT IS 'Monetary Reserve'

‘Monetary Reserve’ refers to central bank holdings of a country’s currency and precious metals. Reserves allow central banks to regulate currency and money supply as well as manage transactions in global markets. And they enable governments to meet current and near-term financial obligations. Reserves are an asset in a country’s balance of payments. The U.S. dollar is the predominant reserve asset, so most central banks hold much of their reserves in dollars.

BREAKING DOWN 'Monetary Reserve'

‘Monetary Reserve’ regulations and requirements have evolved over time. The current system of holding currency and commodities dates from 1971-73. At that time, President Richard Nixon enacted price controls and ended the U.S. dollar’s convertibility to gold in response to rampant inflation plus recession, or stagflation, as well as pressure on dollar and gold prices.

This change marked the end of the Bretton Woods Agreement era. The 1944 Bretton Woods Agreement set the exchange value for all currencies in terms of gold. Member countries pledged that central banks would maintain fixed exchange rates between their currencies and the dollar. If a country's currency value became too weak relative to the dollar, the central bank would buy its own currency in foreign exchange markets to decrease supply and increase the price. If the currency became too expensive, the bank could print more to increase supply and decrease price and thus demand.

Because the United States held most of the world's gold, a majority of countries pegged their currency value to the dollar instead of to gold. Central banks maintained fixed exchange rates between their currencies and the dollar. The value of the dollar increased even though its worth in gold remained the same, making the U.S. dollar effectively a world currency. This discrepancy eventually led to the collapse of the Bretton Woods system.

‘Monetary Reserve’ before Bretton Woods

Until World War I, most countries were on the gold standard, in which they guaranteed to redeem their currency for its value in gold. But to pay for the war, many went off the gold standard. This caused hyperinflation as money supply exceeded demand. After the war, countries returned to the gold standard.

During the Great Depression in response to the 1929 stock market crash, foreign exchange and commodities trading increased, which raised gold prices, so people exchanged dollars for gold. The Federal Reserve raised interest rates to defend the gold standard, worsening the crisis. The Bretton Woods system gave countries more flexibility than strict adherence to the gold standard, with less volatility than with no standard. A member country could change its currency's value to correct any disequilibrium in its current account balance.

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