Why is the dollar the reserve currency?

Have you ever seen what most of the global products are priced in? It is in dollars. It is the most widely used currency in the foreign trade. Most of the countries in the world have significant forex reserves in dollars as compared to other currencies.

Strongest economy post the world wars

The First and Second World Wars cost major economies like England, France, Russia, and Japan a huge amount of money. They significantly invested their budget in financing the war. This led to an increase in the debts of many. The debt levels were very high compared to the GDPs of these nations. The participating countries suffered heavy destruction in their infrastructure. A lot of money was spent on the reconstruction of the infra after the wars.

Unlike the European nations, the United States did not experience much of the war on its own land. It did not suffer the destruction of the infrastructure because of this. The wartime spurred significant technological advancements for the United States. It boosted the manufacturing capacity and emerged as the leading supplier of military equipment.

Being the leading military supplier for the world during the time of long-lasting wars, the United States earned an unequal amount of money. It held a significant amount of gold reserves during this time. With its technological advancements and strong manufacturing and being a major creditor for the allied nations, its large amount of gold reserves strengthened its economic position on a global stage.

The Bretton Woods Conference

Most countries paid for the military supplies and weapons in gold to the United States. This was because gold was the standard against countries that valued their currency. This led to an accumulation of large reserves of gold in the United States. This eventually made gold as a standard for currency valuation only stronger with time.

However, this led to problems for other countries as they started to see depletion in the gold reserves. A new system for currency exchange was the need of time. To solve this problem members of the allied nations came together at Bretton Woods in the US. The aim of this was to establish a standard system to promote a new international monetary policy and encourage global trade.

In the Bretton Woods Agreement, it was decided that all the participating countries would peg their currencies against the United States dollar, which would eventually be valued against gold. The dollar-to-gold value was fixed at $35 against one ounce of gold. This made the economic position of the dollar stronger as every country could do the trade in dollars, as it was insured against the standard of gold. Other countries maintained the exchange rate fixed against the dollar which contributed to the economic dominance of dollar in the international trade.

The Bretton Woods Conference also founded the International Monetary Fund (IMF) which was established to address the issues of international monetary cooperation, exchange rate stability, and balanced economic growth. Member countries contributed funds to the IMF which could be used to address the problems of international trade.

The fall of gold and the rise of oil

After the Bretton Woods Agreement, countries began to accumulate dollars as it was directly pegged against gold. The United States experienced a net current deficit. This slowly led to pressure on the gold reserves. They became vulnerable and began to deplit faster. This threatened the whole international currency system.

This was the era where the rise of oil had begun. Middle Eastern nations found a large number of oil reserves which became an essential commodity for the world. Saudi Arabia was the largest of the oil exporters and the most influential nation in the Middle East. The United States made an agreement with Saudi Arabia against military commitments that the trade of oil would be made in dollars exclusively.

The world was flooded with dollars due to the Bretton Woods Agreement. But to maintain the stability of the gold reserves and with the Saudi oil trade agreement, the United States removed the Bretton Woods Agreement. The dollar was no longer pegged with gold, but with oil now.

Since oil was an essential commodity and its demand only rising, the dollar became stronger and stronger. Most of the nations import oil and pay in dollars. This has made the dollar a stable currency over the past decades and is seen as the reserve currency of the world.