What is a Reserve Currency?

Published by Thomas Herold in Economics, Trading

'Reserve Currency' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Reserve currency proves to be that particular currency which central banks (and sometimes important international financial institutions) hold. They keep such currency so that they are able to have an influence on their own country’s exchange rate or to pay down their debt obligations which are international in nature. A substantial number of global commodities remain priced according to the reserve currency. This includes such heavyweight items as gold and oil. Nations require this currency to acquire these commodity goods.

There is an advantage to keeping quantities of a reserve currency. It allows nations or international companies to reduce their risk of changing exchange rates. The purchaser that possesses the currency reserve will not be forced to exchange their own currency to be able to complete the purchase. Since the last years of World War II in 1944, the American dollar has enjoyed the status of being the principle reserve currency which other countries use globally. This has caused other nations to carefully watch the monetary policy the U.S. pursues to make certain their reserve values do not suffer too much from inflation and currency debasement.

The second reserve currency of the world is the euro used by countries of the euro zone. Countries also can use the SDR Special Drawing Rights created by the International Monetary Fund to settle some international obligations, making it a third currency reserve. Increasingly, nations like China and Russia are trying to shift other nations away from the U.S. dollar as their currency reserve. China is going about this by signing currency exchange swap agreements with as many countries’ central banks as it can to settle in Chinese Yuan.

The U.S. originally gained its status as dominant reserve currency because it came out of World War II as the globe’s main economic power. This had enormous impacts on the economy of the world. In the immediate aftermath of the war, the U.S. GDP comprised 50% of global output. This made it inevitable that its currency the dollar would emerge as the world’s currency reserve as happened in 1944. After this event, a number of other nations decided to peg their exchange rates up to the dollar. The dollar had the backing of gold in those days, making it comparatively stable. This pegging move helped other nations to stabilize their own volatile currencies.

In those early decades, the world as a whole gained advantages from such a stable and strong dollar currency. The U.S. benefited significantly and prospered as it enjoyed the most favorable exchange rate for the dollar. America began to undermine this arrangement when it printed extra dollars. The currency reserve had gold backing it, but the U.S. was able to get around this by issuing dollars that its Treasury debt backed. In time the gold which backed the dollars became less valuable as the dollars multiplied to finance U.S. deficit spending. Other nations’ dollar currency reserves’ value began to decline along with the gold value of paper U.S. dollars.

This eventually had to come to an end. With the U.S. printing and flooding markets with huge quantities of paper dollars to pay for the Vietnam War and Great Society spending, other countries became wary. They started converting their dollar reserves for the gold backing them. This central bank run on the American gold became so severe that President Nixon had no choice but to de-link the dollar from gold and float dollars against other currencies.

This led to the present day system of floating exchange rates. Gold skyrocketed as the dollar commenced its multi decade decline in value which has seen gold prices reach as high as over $1,900 USD per ounce. The dollar still remains the dominant currency reserve mostly because other nations had built up such large amounts of it and U.S. dollar denominated Treasuries.

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The term 'Reserve Currency' is included in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.