A reserve currency is a foreign currency that is held in large quantities by central banks and other financial institutions as part of their foreign exchange reserves. It can be used in international transactions, international investments and all aspects of the global economy.
Debt written in the reserve currency often gets the best interest rates as lenders find more buyers. Wall Street hedge funds prefer debt denominated in the US Dollar since is carries less risk than other currencies. There is also greater liquidity associated with dollar denominated assets.
This also applies to commodities that are priced in the reserve currency. Other countries pay for goods such as oil, gold, and silver, necessitating other nations to hold the currency.
Since 1944, the US Dollar was the primary reserve currency used by other countries. For this reason, nations closely monitor the monetary policy of the Federal Reserve to ensure that the value of their reserves is not adversely affected by inflation or rising prices.
Having the reserve currency minimizes exchange rate risk as the national currency is not exchanged to make purchases.
One of the major utilities is that it acts as a vehicle currency for most other currencies. This acts as the go-between for a transactions between entities that use two different currencies. So neither requires the other, the vehicle currency is used to swap into at one end and out of on the other.
The primary reserve currency is usually accompanied by economic and military might from the country behind it.
It was the Spanish silver dollar that is recognized as the first true global reserve currency recognized in Europe, Asia and the Americas from the 16th to 19th centuries. This was due to the abundant silver supplies from Spanish America.
