The Dollar: The Worlds Reserve Currency Council on Foreign Relations

For example, a flood or opencv introduction volcano might temporarily suspend local exporters’ ability to produce goods. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports. Periodically, the board of governors of a central bank meets and decides on the reserve requirements as a part of monetary policy.

How the U.S. Dollar Became the World’s Reserve Currency

By buying and selling currencies on the open market, a central bank can influence the value of its country’s currency, which can provide stability and maintain investor confidence. For instance, if the value of the Brazilian real starts to fall during an economic downturn, the Central Bank of Brazil can step in and use its foreign reserves to bid up its value. Conversely, countries can intervene to stop their currencies from appreciating and make their exports cheaper. However, some economists, such as Barry Eichengreen, argue that this is not as true when it comes to the denomination of official reserves because the network externalities are not strong.

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Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for instance, has used part of its forex reserves for recapitalizing some of its state-owned banks. The IMF (International Monetary Fund) now includes the yuan, which is also called the renminbi, in a basket of currencies that it uses to help manage countries’ economic problems. Oil, gold, silver and other commodities are priced in the reserve currency, which encourages other nations to hold this currency to pay for them. The entire Euro Area, as designated by the World Bank, is made up of 19 countries.

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As shown in Figure 4, the value of U.S. dollar banknotes held abroad has increased over the past two decades, both on an absolute basis and as a fraction of banknotes outstanding. Federal Reserve Board staff estimate that over $950 billion in U.S. dollar banknotes were held by foreigners at the end of the first quarter of 2021, roughly half of total U.S. dollar banknotes outstanding. Before it entered World War II, the United States served as the Allies’ supplier of weapons and other goods. Most countries paid in gold, making the U.S. the owner of a majority of review financial literacy for millennials gold by the end of the war. A return to the gold standard became impossible as countries depleted their reserves.

Being the country issuing a reserve currency reduces transaction costs, since both sides of the transaction involve the same currency and one is yours. Reserve currency issuing countries are not CM Trading exposed to the same level of exchange rate risk, especially when it comes to commodities, which are often quoted and settled in dollars. The dollar’s centrality to the system of global payments also increases the power of U.S. financial sanctions. Almost all trade done in U.S. dollars, even trade among other countries, can be subject to U.S. sanctions, because they are handled by so-called correspondent banks with accounts at the Federal Reserve. By cutting off the ability to transact in dollars, the United States can make it difficult for those it blacklists to do business. “There’s no doubt that if the dollar were not so widely used, the reach of sanctions would be reduced,” says Setser.

• Others in the basket include the Japanese yen and the British pound sterling.
• When World War I broke out in 1914, many countries suspended the gold standard to pay their military expenses with paper money, which devalued their currencies.
• Currently, all bets are on the Chinese yuan taking over from the US dollar.
• The IMF would also need to be empowered to control the supply of SDR, which, given the United States’ de facto veto power within the organization’s voting structure, would be a tall order.
• But because so much trade is conducted in U.S. dollars, other countries do not always see this benefit when their currencies depreciate.
• During an economic crash, that would put the power of determining the value of the gold reserve, and therefore Russia’s financial fallback, into the hands of the entity willing to purchase it.

The percentage of foreign currency debt denominated in U.S. dollars has remained around 60 percent since 2010, as seen in Figure 8. This puts the dollar well ahead of the euro, whose share is 23 percent. It also buys the local currency to support its value and prevent inflation. The banks prefer to use the cash to buy sovereign debt because it pays a small interest rate.

Euro

Three decades later, the dollar officially became the world’s reserve currency. Starting in the mid-20th century, the U.S. dollar was set as the international reserve currency. Since then, strong economies in many countries have led to the rise of other international reserve currencies. Countries like Germany and China—which have the largest trade surpluses—also have the most currency reserves because they receive U.S. dollars and other foreign currencies when they provide exports. Many experts agree that the dollar will not be overtaken as the world’s leading reserve currency anytime soon. More likely, they say, is a future in which it slowly comes to share influence with other currencies, though this trend could be accelerated by the aggressive use of U.S. sanctions and growing U.S. financial instability.

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. The dollar’s status as the global reserve currency was cemented in the aftermath of World War II by the 1944 Bretton Woods Conference, in which forty-four countries agreed to the creation of the IMF and the World Bank. The reserve status is based on the size and strength of the U.S. economy and the dominance of the U.S. financial markets. In the second quarter of 2024, global central banks held over half of their reserves in U.S. dollars. The most prominent example of a reserve currency is the U.S. dollar (USD).

Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. Russia’s foreign exchange reserves are held mostly in U.S. dollars, much like the rest of the world, but the country also keeps some of its reserves in gold. Since gold is a commodity with an underlying value, the risk in relying on gold in the event of a Russian economic decline is that the value of gold will not be significant enough to support the country’s needs. As of February 2022, Russia’s foreign exchange reserves totaled some $630 billion. However, sanctions imposed by the European Union (EU), the U.S., and other nations in response to Russia’s invasion of Ukraine in February 2022 rendered most of those reserves inaccessible to the central bank. In part because of its dominant role as a medium of exchange, the U.S. dollar is also the dominant currency in international banking.

As long as the currency’s market is sufficiently liquid, the benefits of reserve diversification are strong, as it insures against large capital losses. The implication is that the world may well soon begin to move away from a financial system dominated uniquely by the US dollar. In the first half of the 20th century, multiple currencies did share the status as primary reserve currencies. Although the British Sterling was the largest currency, both the French franc and the German mark shared large portions of the market until the First World War, after which the mark was replaced by the dollar.