9.3 Global Reserve Currencies and the Dollar's Role
4 min read•july 30, 2024
The U.S. dollar's dominance as the global reserve currency stems from America's economic might and financial market depth. It serves as a medium of exchange, unit of account, and store of value in international transactions, shaping global trade and finance.
While the dollar's status brings benefits like lower borrowing costs for the U.S., it also poses challenges. Other currencies like the and renminbi are emerging as potential alternatives, raising questions about the future of the international monetary system.
Reserve Currencies and their Functions
Definition and Characteristics
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- A reserve currency is a foreign currency held in significant quantities by central banks and other major financial institutions as part of their foreign exchange reserves
- The status of a currency as a reserve currency depends on factors such as
- Size and openness of the issuing country's economy
- Depth and liquidity of its financial markets
- Stability of its political and legal systems
- Confidence of international investors in its long-term value
Roles in the Global Monetary System
- Reserve currencies serve three main functions in the global monetary system
- Medium of exchange for international transactions
- Unit of account for denominating international contracts and financial instruments
- Store of value for central banks and investors
- The use of a reserve currency reduces transaction costs and exchange rate risks in international trade and finance allows countries to settle their balances in a widely accepted and stable currency
- The demand for reserve currencies affects
- Their exchange rates
- of the issuing countries
- Global allocation of capital
- Transmission of monetary policy shocks
The U.S. Dollar as Reserve Currency
Historical Emergence and Dominance
- The U.S. dollar emerged as the dominant global reserve currency after World War II
- United States accounted for a large share of world output and trade
- Dollar was backed by gold under the
- The dollar's role as a reserve currency was reinforced by
- Size, depth, and liquidity of U.S. financial markets
- Openness of the U.S. economy to trade and investment
- Political and military power of the United States
- The dollar's share of global foreign exchange reserves has remained around 60-70% since the end of Bretton Woods in the 1970s despite the rise of other major economies and the growth of international financial markets
Contemporary Usage and Influence
- The dollar is used as the invoicing currency for a large share of international trade, especially in commodities such as oil
- The dollar serves as the funding currency for a significant portion of cross-border lending and investment
- The dollar's dominance has allowed the United States to benefit from
- Seigniorage (revenue from the use of dollars abroad)
- Lower borrowing costs
- Ability to finance large current account deficits
- However, it has also exposed the U.S. economy to the effects of global financial cycles and currency fluctuations
Benefits and Costs of Reserve Currency Status
Advantages for the Issuing Country
- Seigniorage revenue from the use of the currency abroad
- Lower borrowing costs due to the high demand for assets denominated in the reserve currency
- Ability to finance large current account deficits without facing a balance of payments crisis
- Enhanced international influence and prestige allows the issuing country's government and firms to conduct transactions and settle disputes in their own currency
Drawbacks and Challenges
- Need to maintain a large and open financial system
- Exposure to global financial shocks and capital flow volatility
- Potential for overvaluation of the currency and loss of competitiveness
- Challenges for the conduct of monetary policy need to consider the effects on the global economy and feedback loops between the exchange rate and domestic economic conditions
Implications for the Global Economy
- Benefits include
- Lower transaction costs
- Reduced exchange rate risks
- Stable anchor for international prices and contracts
- Costs include
- Vulnerability to economic and policy shocks from the issuing country (United States)
- Potential for global imbalances and financial instability
Challenges to Dollar Supremacy vs Alternative Currencies
Potential Challengers
- The rise of other major economies (European Union, China) has challenged the dollar's dominance
- Diversification of central bank reserves away from dollar-denominated assets
- The euro, launched in 1999, has emerged as the second-largest reserve currency accounting for around 20-25% of global foreign exchange reserves
- Constrained by fragmentation of European financial markets and political and economic challenges facing the eurozone
- The Chinese renminbi has been promoted by the Chinese government as a potential alternative to the dollar through measures such as
- Inclusion in the IMF's Special Drawing Rights basket
- Establishment of offshore renminbi markets and bilateral swap agreements
- Limited use as a reserve currency due to China's capital controls and lack of convertibility
- Other potential challengers include the Japanese yen, British pound, and Swiss franc constrained by the size and openness of their economies and depth and liquidity of their financial markets
Prospects for a Multipolar Reserve Currency System
- A multipolar reserve currency system would involve several currencies sharing the functions of a global reserve currency
- Prospects depend on factors such as
- Convergence of economic and financial conditions across major economies
- Coordination of monetary and exchange rate policies
- Development of deep and liquid financial markets in alternative reserve currencies
- Transition to a new global reserve currency or multipolar system could be disruptive to the global economy would involve significant changes in
- Pattern of international trade and investment flows
- Pricing of financial assets
- Conduct of monetary and fiscal policies
Key Terms to Review (15)
Appreciation: Appreciation refers to the increase in the value of a currency relative to another currency. This can significantly impact trade balances, foreign investment, and economic stability, as it affects the cost of exports and imports. When a currency appreciates, it becomes more expensive for foreign buyers, which can decrease export demand while making imports cheaper.
Balance of payments: The balance of payments is a comprehensive record of a country's economic transactions with the rest of the world over a specific period, reflecting all trade in goods and services, investment flows, and financial transfers. This crucial economic indicator helps analyze a nation's economic standing and influences exchange rate determination, monetary policy, and international capital flows.
Bretton Woods System: The Bretton Woods System was a monetary order established in 1944 that created fixed exchange rates between major currencies and the US dollar, which was convertible to gold. This system aimed to promote international economic stability and growth after World War II, influencing the policies of major central banks, shaping the historical evolution of monetary systems, establishing the dollar's role as a global reserve currency, and affecting international capital flows.
Currency substitution: Currency substitution refers to the use of a foreign currency in place of a domestic currency for transactions, savings, and pricing within a country. This phenomenon often occurs in economies with unstable currencies or high inflation, where individuals and businesses opt for a more stable currency to protect their purchasing power. Currency substitution can have significant implications for monetary policy, financial stability, and the overall economic landscape.
Current account surplus: A current account surplus occurs when a country's total exports of goods, services, and income exceed its total imports over a specific period. This situation indicates that a country is earning more from its trade and investments abroad than it is spending on foreign goods and services, which can affect exchange rates and a country’s economic health. A persistent surplus can lead to currency appreciation and may influence the global balance of payments and reserve currency status.
Devaluation: Devaluation is the intentional lowering of a country's currency value relative to other currencies, often executed by the government or central bank. This move is typically aimed at improving trade balance by making exports cheaper and imports more expensive, thus stimulating domestic production and reducing trade deficits.
Euro: The euro is the official currency used by 19 of the 27 member states of the European Union, collectively known as the Eurozone. Introduced in 1999, it serves as a symbol of economic integration among European nations and plays a vital role in the global financial system as a major reserve currency.
Foreign exchange risk: Foreign exchange risk refers to the potential financial loss that arises from fluctuations in the exchange rates of currencies. This risk can affect businesses, investors, and governments engaged in international trade and investment, as changes in currency values can impact the profitability of transactions, the value of assets, and overall economic stability.
Inflation: Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. It plays a crucial role in the economy as it affects money supply, demand, and the overall value of money, impacting how monetary systems evolve and function over time.
International Monetary Fund: The International Monetary Fund (IMF) is an international organization created to promote global economic stability and growth by providing financial assistance, policy advice, and technical assistance to its member countries. The IMF plays a crucial role in the international monetary system, influencing currency values, balance of payments, and global liquidity.
Liquidity Preference: Liquidity preference is the desire of individuals and businesses to hold their wealth in liquid forms, such as cash or easily convertible assets, rather than in illiquid investments. This concept explains how the demand for money varies with interest rates and reflects people's choices on how to allocate their resources between liquid cash holdings and other forms of investment. A higher liquidity preference generally indicates that people are more inclined to keep cash on hand during uncertain economic times, influencing overall money supply and demand in the economy.
Nixon Shock: The Nixon Shock refers to a series of economic measures taken by U.S. President Richard Nixon in August 1971, which included the suspension of the dollar's convertibility into gold. This decision effectively ended the Bretton Woods system of fixed exchange rates and marked a significant shift in global monetary policy, leading to a more flexible exchange rate system. The Nixon Shock not only transformed the role of the U.S. dollar but also altered the dynamics of global reserve currencies.
Plaza Accord: The Plaza Accord was a 1985 agreement among five major economies—the United States, Japan, West Germany, France, and the United Kingdom—to intervene in currency markets to depreciate the US dollar relative to the Japanese yen and German mark. This agreement aimed to correct trade imbalances and stabilize exchange rates, reflecting the interconnectedness of global economies and the influence of exchange rate regimes on international trade.
US Dollar: The US Dollar (USD) is the official currency of the United States and serves as the world's primary reserve currency. It is widely used in international transactions and is a key player in global finance, influencing monetary policies and economic conditions worldwide.
World Bank: The World Bank is an international financial institution that provides financial and technical assistance to developing countries to reduce poverty and promote sustainable economic development. It plays a vital role in shaping global economic policies and financing projects that aim to improve infrastructure, education, and health systems in emerging economies.