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Have you ever wondered what's going on in the United States and why it is so popular across the globe? Well, it's not only because of the years of colonialization. It's mostly because of its unique and strong position in the financial and trading scene.
For this lesson, you'll explore the US Dollar's global implication and the factors contributing to its economic appeal.
The role of the USD as the global reserve currency is the most crucial aspect of why it's considered the world's currency.
Let's first define what a reserve currency is;
As the name suggests, the reserve currency is a currency that the central banks reserve or hold. However, they don't simply hold this currency; they make sure that they reserve significant quantities that will be used for multinational transactions.
Why do they reserve USD? It's because the USD is stable and the most popular currency worldwide.
Also, most financial transactions and international trades are pegged in USD. This makes cross-currency transactions only possible if the bank's currency is converted to USD.
So, it's safe to conclude that having a significant amount of USD reserves eliminates huge transactional costs on the central bank's end.
But that's not all.
Remember, many major currencies can afford expensive fees for cross-currency transactions. One of the main uses of USD reserves is bolstering the stabilization of their own currency due to heightened participation in global trade.
With these benefits, the financial world has seen the dominating hype for the USD over the decades. Today, central banks hold an average of 60% of their forex reserves in dollars.
Yes, that many!
Note: Coming second is the Euro, which makes up around 20% of central bank reserves.
Due to its reserve currency status and importance to global trade, the USD has become widely used for pricing commodities. This includes popular commodities like;
The practice of quoting commodities in USD is also known as dollar terms or dollar-denominated pricing.
The reason for this? Well, it's because quoting in USD simplifies the global commodities market. With USD, international commodity market participants spare themselves from the trouble of multiple currency conversions because most of their assets are denominated in USD.
After the economic disruption caused by World War II, a new monetary system was made to promote economic stability and international trade. It was in the form of the Bretton Woods system.
This monetary system suggested that each currency value must be pegged to the US Dollar to ensure fixed rates on cross-currency transactions.
The system also established the International Monetary Fund (IMF) and the World Bank to promote international economic cooperation and development.
The International Monetary Fund (IMF) oversees the international monetary system, which aims to promote proper and stable rating systems.
The IMF provides financial assistance to all its member countries that are facing balance of payments problems. A resolution concerning the balance of payments problems would help address the country's economic imbalances.
Additionally, the IMF facilitated international monetary cooperation by offering policy advice, conducting economic research, and providing a forum for discussion among member nations to address global economic challenges.
Formally known as the International Bank for Reconstruction and Development (IBRD), the World Bank primarily aims to help war-torn countries recover from infrastructure disruptions. The financial assistance was mainly for the post-war reconstruction and development projects in war-torn countries.
Over time, its mandate expanded to supporting economic development and reducing poverty in developing countries. The assistance is done by providing the following;
The World Bank focuses on long-term development projects such as infrastructure, education, healthcare, and environmental sustainability to promote economic growth and improve living standards in member countries.
The Bretton Woods system ended in the early 1970s due to various factors. This includes the United States' inability to maintain the gold convertibility of the dollar and mounting economic pressures.
This led to the transition to a system of floating exchange rates, where currency values are determined by market forces rather than fixed exchange rates.
Even after the Bretton Wood System ended, the USD remains in its highest position among all the currencies worldwide.
That is mainly because of its reserve currency status. As discussed in this lesson, the US Dollar has been the world's primary reserve currency since the end of World War II until now. Central banks globally reserve significant amounts of USD to help stabilize their economy and provide liquidity to the global financial system.
Also, its worldwide network has made the USD international transactions a self-reinforcing cycle. With this, most non-American individual investors and businesses opt to use USD for their trading transactions instead of their own currency.