Reserve Currency
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What Is Reserve Currency?
A reserve currency is a currency widely held by central banks as part of their foreign exchange reserves and widely used to settle international trade and finance. Because so many transactions, contracts, and commodity prices are denominated in it, a reserve currency is in constant demand around the world. The U.S. dollar has been the dominant reserve currency since the mid-twentieth century, a role cemented under the Bretton Woods system, in which participating currencies were pegged to the dollar, which was itself convertible to gold at a fixed price. Other currencies, including the euro, the Japanese yen, and the British pound, are also held in reserves, though in smaller shares.
Why It Matters
Holding the world's leading reserve currency confers significant advantages, sometimes called an 'exorbitant privilege.' The issuing country can borrow more cheaply and in its own currency, and its financial markets attract steady global demand, which helps finance persistent trade deficits. Reserve status also gives the issuer geopolitical leverage, since much of world trade and finance flows through its banking system. But the role carries obligations and risks: the issuer must supply enough of its currency to meet global demand, and shifts in confidence can have outsized effects. Debate recurs over whether the dollar's dominance will fade as other economies grow and as some countries seek alternatives, though no rival has yet matched the dollar's depth and acceptance.
Test Your Knowledge
Questions on this topic from the EconRecall fact bank:
- What is a "reserve currency"?
A currency widely held by central banks as foreign exchange reserves and widely used to settle international trade - Before floating the baht in July 1997, the Bank of Thailand had been doing what in an ultimately unsuccessful effort to defend its currency's peg?
Spending down its foreign currency reserves - Following the crisis, many Asian countries adopted what precautionary financial strategy to guard against future speculative currency attacks?
Building up large foreign exchange reserves