What is a Reserve Currency?
A reserve currency is a national currency that is widely used and accepted in international transactions. It is usually the currency of a country with a large and influential economy.
It is often used as a reference currency for other currencies. For example, the U.S. dollar is often considered the reserve currency in the global economy because it is widely used in international trade and financial transactions.
To ensure confidence and international acceptance as an investment and reserve currency, the reserve currency country must have stability in the value of the currency through sustainable oriented monetary and fiscal policies. In addition, the country must play a significant economic and political role in the global economy.
These criteria continue to be best met by the United States. The U.S. dollar is currently involved in 88% of all global foreign exchange transactions, while the euro is the second most important currency, used for 31% of all transactions.
The British pound and yen compete for third place. The U.S. dollar also dominates as an international reserve currency, holding 62% of the world's foreign exchange reserves, while the euro has a share of only around 20%.
The U.S. dollar gained its function as a reserve currency primarily through the Bretton Woods system of fixed exchange rates with the gold standard, which was established after World War II. The dollar had a fixed exchange rate to gold.
All other currencies each had a fixed exchange rate against the U.S. dollar as their reserve currency, which indirectly backed them with gold.
The need for this construct with the U.S. dollar as the reserve currency was due to the fact that at the end of World War II about 70% of the world's gold reserves were stored in the United States.
The U.S. dollar in the Bretton Woods system replaced the British pound as the world currency of the 19th and early 20th centuries. This led, among other things, to the rise of the United States as a world power and the simultaneous loss of economic and political importance of Great Britain.
Even after the end of the Bretton Woods system and the gold standard in the early 1970s, the U.S. dollar retained its status as reserve currency. The main reasons for the predominance of the dollar in commodity trading, especially the globally significant trade in oil (petrodollars).
On the other hand, the U.S., with its liquid and significant financial market, is considered a safe haven. At the same time, the attractiveness of the U.S. dollar as an investment and reserve medium has increased significantly over the past decades as a result of various financial crises in developing countries in the 1980s and 1990s.
In addition to these factors contributing to strong demand for the U.S. dollar, the currency also benefits from the network effect. The increasing use of a currency as a transaction medium provides incentives for market participants to also use the same currency to conduct their international business.
In summary, a reserve currency is a currency that serves as a benchmark for the value of other currencies and for international transactions on an international level.
The U.S. dollar is currently the world's reserve currency because of its widespread use in many areas, such as commodity trading and as a reserve currency for central banks.
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