Loading the player...

What is a 'Reserve Currency'

A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions to prepare for investments, transactions and 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 a reserve currency minimizes exchange rate risk, as the purchasing nation will not have to exchange its 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 only made sense that the U.S dollar would become the global currency reserve. In 1944, following the Bretton Woods Agreement, delegates form 44 nations formally agreed to adopt the U.S. dollar as an official reserve currency. 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 exchange rate on its currency. The foreign governments did not fully realize 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 U.S. Dollar

The U.S. dollar remains the world’s currency reserve, due primarily to the fact that countries 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.

Reserve Currencies Today

In 2010, the United Nations Conference on Trade and Development released a report suggesting the development of a global currency to replace the U.S. dollar as the world's dominant reserve currency because of the instability of its value in the global market. But that has yet to change, as the dollar remains the world's official reserve currency and is still the most held. The euro, introduced in 1999, is the second most commonly held reserve currency and in October 2016, the International Monetary Fund declared China's renminbi (RMB) as an official reserve currency. 

RELATED TERMS
  1. Key Currency

    A key currency used is money issued by stable, developed country ...
  2. Reserve Assets

    Reserves are external assets held by central banks to alleviate ...
  3. Currency

    Currency is a generally accepted form of money, including coins ...
  4. Dollar Rate

    The dollar rate is the exchange rate of a currency against the ...
  5. Currency Board

    A currency board is a monetary authority that makes decisions ...
  6. International Currency Exchange ...

    An international currency exchange rate is the rate at which ...
Related Articles
  1. Insights

    A Primer On Reserve Currencies

    For nearly a century, the U.S. dollar has served as the world's premier reserve currency, but the future is uncertain.
  2. Investing

    Will the Yuan Become an International Reserve Currency?

    Although still a matter of when, China is likely to reach a significant milestone when the International Monetary Fund decides to include the Chinese yuan in its special drawing rights basket ...
  3. Trading

    How The Triffin Dilemma Affects Currencies

    Countries that issue reserve currencies are faced with a dilemma: keep other countries happy or achieve domestic monetary policy goals.
  4. Insights

    The Go-To Currency In 50 Years

    Discover why the euro will likely become heir to the currency throne.
  5. Trading

    The U.S. Dollar: What Every Forex Trader Needs To Know

    The U.S. dollar is by far the most significant currency in the global market. Find out what you need to know if you want to trade it.
  6. Trading

    10 Countries With The Biggest Forex Reserves

    Without adequate reserves, a nation's economy can grind to a halt. Here are the 10 nations with the biggest forex reserves.
  7. Trading

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  8. Trading

    What Would It Take for the U.S. Dollar to Collapse?

    Quantitative easing raised concerns about the dollar's vulnerability, but a review of the dollar's strengths and weaknesses suggests that a currency crisis is unlikely.
  9. Trading

    6 top-traded currencies and why they're so popular

    Every currency has specific features that affect its underlying value and price movements in the forex market.
RELATED FAQS
  1. How are international exchange rates set?

    Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments ... Read Answer >>
  2. What countries have the largest gold reserves?

    Find out which countries have the largest gold reserve stockpiles, and learn why governments still feel that it's necessary ... Read Answer >>
  3. Why is the U.S. dollar shown on the top of some currency pairs and on the bottom ...

    All currencies are traded in pairs. The first currency in the pair is called the base currency while the second is called ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center