Instead of Other Currencies, Why the U.S. Dollar Became the World’s Reserve Currency
The United States of America is the world’s leading superpower. It is not only for its strong military capability but also for its dominant economy all over the world. More than 61% of all foreign bank reserves are denominated in US dollars in 2019.
Most of the transactions of international trade are accomplished in US dollars. So How did the US Dollar become the most dominant global currency?
To clarify the concept, I want to go back to a short history of international currency.
U.S. Surpassed the U.K. Economy
Before 1913, each commercial bank of the United States issued its own notes. The Federal Reserve Act of 1913 created the Federal Reserve Bank to respond to the unreliability and instability of a currency system.
This was the same time when the United States economy was going to become the world’s largest, surpassing that of the United Kingdom. Before that International Economy was centered around the U.K. and the majority of transactions took place in British pounds.
The majority of developed countries pegged their currencies to gold to sustain the reliability and stability of their currencies. When the first World War broke out many countries suspended the use of gold to afford the cost of war and started using paper money, resulting devalued their currencies.
Till then the UK held its first place as a country of leading currency by maintaining the gold standard. But it could not hold the place. It had to borrow money for the first time during the third year of the war.
At that time U.S. introduced an opportunity to lend U.S. bonds. Many countries bought dollar-denominated U.S. bonds. Britain finally abandoned the gold standard in 1931 and the dollar replaced the pound as the leading international reserve currency.
The Bretton Woods Agreement
During the Second World War, the U.S. joined the combat after it began well. Before joining the war the U.S. served weapons and goods to its Allies as the main supplier. As most of the countries paid in gold, the U.S. became the owner of the majority of the world’s gold by the end of the war. This made a return to the gold standard impossible for the countries that depleted their reserves.
Delegates of 44 allied countries got together in Bretton Woods, New Hampshire, in 1944 to fix the issue of how the foreign exchange would be and how every country could get the same advantage in an international transaction. The delegation decided that the world’s currencies would no longer be linked to gold but could be pegged to the U.S. That’s because the greenback was, itself, linked to gold.
This arrangement came to be known as the Bretton Woods Agreement. This Agreement also established the authority of central banks in every country, which would maintain fixed exchange rates between their currencies and the U.S. dollar. United States would redeem U.S. dollars for gold on demand.
The member countries had some degree of control over their currencies in situations wherein the values of their own currencies became too weak or too strong relative to the U.S. dollar. They could buy or sell their currency to regulate the money supply.
Becoming the World’s Reserve Currency
By the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency which was backed by the world’s largest gold reserves. Instead of gold reserves, other countries accumulated reserves of U.S. dollars.
By the 1960s, however, the United States did not have enough gold to cover the dollars in circulation outside the United States, leading to fears of a run that could wipe out U.S. gold reserves. The United States failed to save the system of issuing dollars against the gold reserve.
This was happened mainly because of expending of Vietnam War and the Great Society domestic programs. It caused the United States to flood the market with paper money.
With growing concerns over the stability of the dollar, the countries began to convert dollar reserves into gold.
The demand for gold was such that in August 1971 President Richard Nixon was forced to de-link the dollar from gold, which led to the floating exchange rates that exist today. This event is known as the “Nixon Shock” in the history of currency.
Moreover, the U.S. dollar remains king in world currency. In addition to accounting for the bulk of global reserves, the dollar is the currency of choice for international trade.
Factors that contribute to the U.S. dollar’s dominance:
- Its Stable Value
- The Size of the U.S. Economy
- The Geopolitical heft of the United States
- The U.S. is the largest lender country
- No currency can compete with the U.S. dollar till now
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