What Is a Monetary Reserve?
A monetary reserve is a central bank's holdings of a nation's currency and precious metals. These central bank holdings allow for the regulation of the nation's currency and money supply, as well as help manage liquidity for transactions in global markets. Monetary reserves help governments to meet current and near-term financial obligations. Reserves are an asset in a country’s balance of payments.
In addition to domestic reserves, central banks typically hold foreign currency reserves as well. The U.S. dollar is the dominant reserve asset, so most nations central banks hold much of their reserves in U.S. dollars.
- Monetary reserves refer to the currency, Treasuries, and other assets held by a central bank.
- Central banks maintain monetary reserves to regulate the money supply in a nation.
- When more money is needed in an economy, the central bank can increase the amount of monetary reserves, which it can then provide to commercial banks.
Understanding Monetary Reserves
Monetary reserves are part of a country's monetary aggregates, which are broad categories that define and measure the money supply in an economy. In the United States, the standardized monetary aggregates include physical paper and coins, money market shares, savings deposits, and other items, and are termed M0, M1, and M2.
A country's central bank monetary authorities will use their readily available reserve assets to fund currency manipulation activities within the nation's economy. Central banks will also maintain international reserves which are funds that the banks can pass among themselves to satisfy global transactions. Reserves themselves can either be gold or a specific currency, such as the dollar or euro.
History of the Monetary Reserve
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 the 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.