Reserve Currency Standard

In a reserve currency system, another country’s currency takes the role that gold played in a gold standard. In other words a country fixes its own currency value to a unit of another country’s currency. For example, suppose Britain decided to fix its currency to the dollar at the exchange rate E_$/£ = 1.50. To maintain this fixed exchange rate, the Bank of England would stand ready to exchange pounds for dollars (or dollars for pounds) upon demand at the specified exchange rate. To accomplish this, the Bank of England would need to hold dollars on reserve in case there was ever any excess demand for dollars in exchange for pounds on the FOREX. In the gold standard the central bank held gold to exchange for its own currency, with a reserve currency standard it must hold a stock of the reserve currency. Always, the reserve currency is the currency to which the country fixes.

A reserve currency standard is the typical method for fixing a currency today. Most countries that fix its exchange rate will fix to a currency that either is prominently used in international transactions or is the currency of a major trading partner. Thus, many countries fixing their exchange rate today fix to the US dollar because it is the most widely traded currency internationally. Alternatively, 14 African countries that were former French colonies, had established the CFA franc zone and fixed the CFA franc to the French franc. Since 1999, the CFA franc has been fixed to the Euro. Namibia, Lesotho, Swaziland are all a part of the common monetary area (CMA) and fix their currency to the South African Rand.

International Finance Theory and Policy - Chapter 80-3: Last Updated on 4/7/05