What is Reserve Currency?

Certain currencies of the world have been used throughout history as a means of international exchange. A currency that is held by many governments and institutions, and used by them to pay off international debts or influence their exchange rates, is known as a reserve currency. For many years, and especially since World War II, the U.S. Dollar has been the most widely used reserve currency, due to its reputation for stability, among other reasons. Many commodities which are used worldwide, such as gold and oil, are priced in U.S. Dollars, making it a good practice for countries to keep dollars on hand to purchase these commodities.

Any currency that is widely recognized and trusted can serve as a reserve currency. The idea of reserve currency has existed in one form or another for centuries. However, the modern international banking system has cemented the need for one much more so than older economic structures. Central banks around the world may hold funds in a variety of currencies in reserve, in addition to their own. They do this mainly to store value, as much as a backup for their own currency as for strategic reasons, should any contingency arise. Any of the foreign currencies used in such a manner could be thought of as a reserve currency.

Traditionally, the U.S. Dollar has been the preferred reserve currency of the world. Roughly two thirds of worldwide currency reserves are held in dollars. More recently, the Euro has seen increased use as a reserve currency. This is perhaps partly because many of the currencies of the countries that now make up the European Union were used as reserve currencies before the Euro was adopted for wide use. Because of the popularity of the Euro, there is considerable debate and speculation as to whether it will eventually replace the Dollar as the world's most preferred reserve currency.

After World War II, the global financial system was redesigned to place the U.S. Dollar at the center. The U.S. bought gold from participating nations, promising them that they could trade their dollars for gold at a fixed rate at any time they wished. The nations of Europe, as well as Japan, allowed their currencies to be devalued under this system in order to make their exports competitive in a world market. This universal gold standard was known as the Bretton Woods System, and lasted until the 1970s, when the U.S. effectively terminated the ability of other countries to convert their dollars into gold.