FAQ: What is a reserve currency? Why do central banks stockpile gold?

A reserve currency is a currency that is held in significant quantities by governments and institutions as part of their foreign exchange reserves. The history of reserve currencies can be traced back to the late 19th and early 20th centuries, when the gold standard was widely used. Under the gold standard, paper currency was backed by gold, and the value of a country’s currency was tied to the amount of gold it held. The British pound was the dominant reserve currency during this period.

After World War II, the Bretton Woods Agreement established the US dollar as the dominant reserve currency, replacing the pound. The US dollar became the anchor currency for the international monetary system, and the value of other currencies was fixed to the dollar, which in turn was pegged to gold. The US dollar continued to be the dominant reserve currency until the collapse of the Bretton Woods system in the 1970s.

Since then, the US dollar has remained the dominant reserve currency, but its dominance has been challenged by the rise of other currencies, particularly the euro. Today, the US dollar, euro, Japanese yen, and British pound are the most widely held reserve currencies, and the US dollar continues to be the dominant currency in international transactions.

Whatever happened to the Gold Standard?

The gold standard was abandoned because it became increasingly difficult to maintain the fixed exchange rate between gold and paper currency. The difficulty arose because of the growing economic imbalances between countries and the increasing amount of money in circulation, which made it more difficult to redeem paper currency for gold. Additionally, the costs of maintaining the gold standard, such as the need to hold large amounts of gold in reserve, became increasingly onerous.

The abandonment of the gold standard was accelerated by the increasing costs of the Vietnam War and other factors that put pressure on the US economy. The US government’s attempts to finance the war by printing money led to inflation, which made it increasingly difficult to maintain the fixed exchange rate between the US dollar and gold. In 1971, the US government suspended the convertibility of the US dollar into gold, effectively ending the Bretton Woods system and the gold standard.

After the collapse of the Bretton Woods system, most countries abandoned the gold standard and adopted floating exchange rate regimes, in which the value of a currency is determined by market forces, rather than being tied to a specific commodity such as gold. Today, the gold standard is no longer used, and the value of currencies is determined by a combination of market forces and government intervention.

Today, no country uses the gold standard as a means of determining the value of its currency. The gold standard was widely abandoned after the collapse of the Bretton Woods system in the 1970s, and today most countries have adopted floating exchange rate regimes, in which the value of a currency is determined by market forces, rather than being tied to a specific commodity such as gold.

There have been occasional calls to return to a gold standard, particularly among some economists and political figures who view it as a way to curb inflation and stabilize currencies. However, the idea has not gained widespread support. It would greatly curtail the amount of money governments would be able to borrow or create. Also there are significant practical and economic challenges to re-adopting the gold standard, particularly given the much larger size of modern economies and the greater diversity of financial instruments and markets.

Central banks do still hold gold in reserves however, for several reasons.

1. Store of Value: Gold is a highly valued precious metal and has been used as a store of value for centuries. Central banks hold gold reserves as a means of diversifying their portfolio and to provide a store of value that is less vulnerable to inflation and currency fluctuations.
2. Currency Backing: Historically, central banks have used gold as a backing for their currency. For example, the US dollar was once backed by gold, with the Federal Reserve holding a significant amount of gold reserves to ensure that the value of the dollar remained stable.
3. Liquidity: Gold is highly liquid, meaning that it can be easily sold on the global market. In times of economic crisis, central banks may need to quickly raise funds, and selling their gold reserves can provide a source of liquidity.
4. Confidence and Reputation: Gold reserves can enhance a central bank’s credibility and reputation. Holding a significant amount of gold signals to other countries and investors that the central bank has the financial resources and stability to weather economic storms.

Overall, central banks hold gold reserves as a means of diversifying their portfolio, ensuring stability and confidence in their currency, and providing a source of liquidity in times of crisis.

The first and third reasons also apply to YOU! Keeping precious metals as a highly liquid store of wealth is every bit as good an idea for you as it is for a central bank.