Overview of Reserve Currency

Reserve currency is the foreign currency held by central banks and major financial institutions in order to cover international debt obligations, make major expenditures and influence currency exchange rates. Until World War II, the most common reserve was United Kingdom's pound sterling. After World War II, it was supplanted by the U.S. dollar. And while the Euro and the Japanese Yen has been gaining ground in recent years, the dollar continues to dominate. Today, the health of the international markets is directly tied to the strength of the dollar. If the dollar collapses, the results would be catastrophic for every country on the planet.

Understanding Reserve Currencies

Every country issues it's own currency. It's value largely depends on the country's economic and political conditions. Generally speaking, the more prosperous and politically stable the country is, the more it's currency is worth. Furthermore, stability and prosperity ensures that the value of the country's currency won't change significantly.

This combination of value and stability made some currencies desirable above most of the others. The countries purchased them as a way to ensure that they will have currency that's worth something even if their economic and political problems would cause the values of their own currencies to plummet. They became known as reserve currencies. Private banks, especially large banks followed their lead.

Having reserve currencies have other benefits. Because of their stability and value, reserve currencies are often go-to currencies for international trade. This is especially true when it comes to precious metals such as gold and natural resources such as oil. Another benefit of having international currencies is that it props up the value of the currencies of the countries that bought them. That's because having this reserve of wealth strengthens the economy and makes it that much more linkey that the country will overcome it's economic difficulties.

United States Dollar and Reserved Currency

U.S. Dollar stands apart from all other reserve currencies because it acts as a linchpin for the international economy. When World War II ended, most developed countries struggled to deal with enormous damage brought on by warfare within their borders, as well as the equally massive losses of life. Since combat never reached the American shores, the United States emerged in a much stronger position. The American dollar has become the de facto reserve currency for the rest of the world. It also became the the baseline for the currency exchange rates. Whereas before, the currency exchange rates were set by comparing the values of each currency, the post-World War II exchange rates are set by comparing the value of one currency against the value of the dollar.

During the first few decades, this arrangement worked for everyone. Countries used sizable dollar reserves to prop up their currencies and shore up their economic prosperity. Because it held the reserve currency, the United States had an advantage when it came to trade negotiations and international financial transactions.

However, as United States went through several recessions, other countries started to have second thoughts about relying on it's currency. If the dollar collapses, a decent portion of their reserves would be wiped out and the currency exchange system would fall apart. Even under the best-case scenario, it would still have an adverse affect on the global economy and international trade. The fallout from the collapse of the housing bubble reinforced their concerns. As the results, many developed and developing countries have been advocating switching to another currency, or perhaps a neutral currency. So far, those efforts have not born fruit. While countries have been increasingly buying Euros and yen in hopes of lessening their dependence on the dollar, those currencies are still not strong enough or widespread enough to truly rival the dollar.

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