Reserve currency is a representative of currency, which institutions and governments hold in significant quantities as a major form of foreign exchange reserve. It also acts as internationally appreciated pricing currency in the global market where products and commodities like gold, silver, and oil are traded.
This currency creates an opportunity for various nations to conduct their international trade in an environment that is favorable. This occurs since the reserve currency is globally accepted as the currency for conducting international trade. Therefore, without a reserve currency, global business activities cannot occur effectively due to difficulties experienced in the process of currency exchanges among nations.
The US dollar attained the status of reserve currency towards the end of World War II (Eichengreen, & Flandreau, n.d). During this period, there was a stiff competition between the sterling and the dollar on which currency should be regarded as the reserve one. This competition was based on the desire to have an effective financial and interwar economic history so that foreign exchange in the future would effectively occur (Eichengreen, & Flandreau, n.d).
Sterling had a leading position as the reserve currency during the interwar era. This took place irrespective of the ability of the United States to take a leading position of the United Kingdom in terms of financial power and commercial activities, and dominate the economy. Nevertheless, the attainment of a commercial and economic imbalance between the competing countries led to the shift of the reserve currency from sterling to dollar. This remarkable shift occurred immediately after World War II (Eichengreen, & Flandreau, n.d).
Politics plays a significant role in determining, which currency should be regarded as the reserve one. Actually, financial, commercial, and economic powers may not grant a currency the status of being a reserve one. This illustrates that there is a strong political force, which dictates the power of currency of one country in comparison to another. This is what happened in case of sterling and dollar when competing for the reserve currency position.
Several dynamics were experienced as the political systems kept on changing. These dynamics were the following. First, sterling had taken a lead as the reserve currency, and then it was overtaken by dollar as the leading currency over a short period (Eichengreen, & Flandreau, n.d).
Despite these dynamics, dollar got a strong backing from the well-established political system of the United States, which was influential and allowed its currency to have a leading position in the world. Since then, several nations have attempted to outweigh the dollar, but weaker political, financial, commercial, and economic power of those countries as compared to the United States’ one resulted only in making those currencies become reserve ones of the corresponding state.
Moreover, the United States dollar dominated the economies and networks of other countries. This was evidenced by the ability of dollar being exchanged for gold. As such, countries exchanged gold for a dollar. This gave dollar an opportunity to effectively dominate the economy of the countries. Therefore, dollar’s dominance granted it an opportunity of attaining the status of reserve currency for global market activities.
Bretton Woods Agreement was another factor, which contributed to making the United States dollar a reserve currency (InvestorsInsight.com, 2012). This agreement involved approximately 44 delegates from various allied nations. The delegates were converged in New Hampshire.
This conference was held at the end of World War II. The main reason behind this meeting was that the financial and economic systems at international levels were not stable. As such, this conference focused on formulating strategies needed for adoption and implementation in order to stabilize these systems at the international level.
The Bretton Woods system had several features. One of these features was that all countries had the mandate of complying to the established monetary policies (InvestorsInsight.com, 2012). These monetary policies demanded that there should have been a universal fixed exchange value so that international business activities would effectively occur without any limitation.
As such, the United States dollar was adopted as the fixed value (reserve currency) to be used in the process of conducting various global business activities. In addition, all financial institutions and central banks had to adopt dollar as the currency for settling any international debt and determining the exchange rates of their domestic currencies.
This illustrates that there was a mutual agreement of the delegates on the adoption of dollar as the reserve currency. This mutual agreement was based on the political, financial, commercial, and economic power of the United States. Nevertheless, dollar does not have a standard value since it keeps on fluctuating.
This is evidenced by the fact that at times, it increases and decreases. Despite this condition of the dollar, Americans do not feel the impact of these fluctuations since they keep on carrying out their daily business activities effectively. This illustrates that the ability of dollar to fluctuate without significantly impacting the living standards of Americans allows it to have the power of becoming a reserve currency.
Bretton Woods Agreement compelled other allied nations to adopt the United States dollar as the exchange rate for global business activities (InvestorsInsight.com, 2012). Consequently, these allied nations had to buy as well as sell dollar in order to ensure that the market exchange rates remained within the anticipated levels of parity.
Furthermore, the ability of the United States dollar to be backed by gold gave this currency a higher purchasing power in comparison to other currencies. This included making dollar a dominant currency for exchanging with gold. These conditions strengthened the power of the dollar so that it was able to attain the status of a reserve currency.
The use of dollar as the exchange rate for the gold illustrates that during that period, there was a lack of a universal currency, which could be substantiated to the value of the gold. However, the ability of dollar to posses the characteristics, which make it acceptable as the universal currency for exchanging gold allowed it to dominate the global market of gold trade.
This acted as the beginning of the ability of dollar to acquire the required market dominance of a reserve currency. As such, the delegates met in New Hampshire, and each of them saw the potential and ability of dollar being a reserve currency. Therefore, it was obvious that these delegates had to agree mutually on using dollar as the reserve currency. This is because dollar gained a wide acceptance as a currency for conducting international trade, which other currencies could not gain at all.
Reference List
Eichengreen, B, & Flandreau, M. (n.d). The Rise and Fall of the Dollar, or When did the Dollar Replace Sterling as the Leading Reserve Currency?
InvestorsInsight.com. (2012). Will the US Dollar Lose “Reserve Currency” Status?