Monetary Reserve: What it is, How it Works, History

What Is a Monetary Reserve?

A monetary reserve is the holdings of currencies, precious metals, and other highly liquid assets used to redeem national currencies and bank deposits and to meet current and near-term financial obligations by a country’s central bank, government treasury, or other monetary authority. These holdings facilitate the regulation of the country’s currency and money supply, as well as help manage liquidity for transactions in global markets. Reserves are an asset in a country’s balance of payments.

In addition to domestic reserves, central banks typically hold foreign currency reserves as well. The U.S. dollar is the dominant reserve asset, so most countries’ central banks hold much of their reserves in U.S. dollars.

Understanding Monetary Reserves

All modern economies are characterized by monetary systems based on the issuance of circulating money in the form of bank deposits or other money substitutes through the process of fractional reserve banking. Banks and any other issuers of new deposits hold reserves of physical cash, highly marketable assets and their own reserve deposits on account at the central bank equal to some fraction of their total deposits in order to meet demand for cash withdrawals by their customers and other creditors. Central banks, government treasuries, and other national or international monetary authorities likewise hold reserves of precious metals, liquid assets, and paper notes against redemption demands by banks and financial institutions. These constitute monetary reserves, and represent the base upon which a country's money supply is built like a pyramid through the system of fractional reserve lending in the banking and financial system. 

Monetary reserves are part of a country's monetary aggregates, which are broad categories that define and measure the money supply in an economy. In the United States, the standardized monetary aggregates include physical paper and coins, money market shares, savings deposits, and other items, and are termed M0, M1, and M2.

A country's central bank or other monetary authorities will use their readily available reserve assets to fund currency manipulation activities within the nation's economy. Central banks will also maintain international reserves which are funds that the banks can pass among themselves to satisfy global transactions. Reserves themselves can either be gold or denominated in a specific currency, such as the dollar or euro.

History of the Monetary Reserves

National and international standards of the kinds of assets, their exchange rates, and the necessary amounts that must be held as monetary reserves have evolved over time through history.

Precious Metal Standards

Until the 20th century, gold and/or silver were the primary monetary reserves. Countries legally defined their currencies in terms of fixed weights of gold or silver and banks, including central banks, issued paper notes and certificates of deposit backed by fractional reserves of precious metals. 

Global political and economic dominance of a few major powers eventually led to the adoption of gold-exchange standards among many countries. Under these arrangements smaller and emerging countries, colonies, and minor allies of major powers pegged their currencies to the currencies of and held bank reserves in the currencies and paper notes of major countries such as the British pound or the U.S. dollar.  

Periodically, countries would halt or limit redemption of their treasury and bank notes and deposits for precious metals in order to engage in rapid inflation of their paper money supply, usually to finance war spending or to bail out overextended banks, without depleting their precious metal reserves. This was known as “going off the gold standard” and sometimes caused hyperinflation as the supply of paper money and bank deposits, relieved of the limit of gold redemption, greatly expanded. 

After a time they would return to the gold standard, often at greatly depreciated currency values relative to gold. Over time, with successive episodes of monetary inflation, these periods became more frequent and lasted longer, ultimately leading to the total breakdown and abandonment of the gold standard with during the Great Depression and World War 2.

Bretton Woods

After World War 2 a new gold exchange standard known as the Bretton Woods Agreement was negotiated among the major Western economies. The 1944 Bretton Woods Agreement set the exchange value for all currencies in terms of U.S. dollars and the dollar was pegged to gold at $35 per ounce. Member countries pledged that central banks would maintain fixed exchange rates between their currencies and the dollar. If a country's currency value became too weak relative to the dollar, the central bank would sell dollars and buy its own currency in foreign exchange markets to decrease supply and increase the price. If the currency became too expensive, the bank could print more to increase supply and decrease price and thus demand.

Because the United States commanded superpower status over Europe and other Westernized economies and held most of the world's gold, the U.S. dollar was still pegged to gold. This made the U.S. dollar effectively a world currency, though other countries' central banks could still redeem their dollars for gold from the U.S. at $35 per ounce. International demand for dollars as the primary monetary reserve used by other nations allowed the U.S. Federal Reserve to engage in expansionary monetary policy to encourage domestic growth and subsidize the federal debt with less risk of domestic price inflation.

However the ever growing supply of dollars in the global financial markets by the 1960’s led to a mismatch between the world price of gold and its redemption value at the Fed, as the Fed pumped up the supply of dollars to simultaneously fund domestic Great Society welfare spending and the Vietnam War. This discrepancy eventually led to the collapse of the Bretton Woods system as foreign banks redeemed their highly overvalued dollars for gold at $35.

The Closing of The Gold Window

The current system of holding currencies and commodities as monetary reserves against floating currencies dates from 1971-73. At that time, President Richard Nixon ended the U.S. dollar’s convertibility to gold in response to rampant redemption of U.S. dollars for gold by foreign governments and the possibility that the U.S. would run out of gold reserves. This severed the last official link of the dollar and other national currencies to gold. Since then, paper Federal Reserve notes and bank deposits can not be redeemed at banks for anything other than different Federal Reserve notes.

From 1971 onward central banks and other monetary authorities worldwide have held a mix of foreign currencies and government debt as monetary reserves. Monetary reserves today consist of notes, bonds, or other financial instruments that represent promises to pay in the form of future notes rather than any actually useful or valuable commodity. Many institutions also still hold gold, domestically or on account in storage vaults at the Federal Reserve Bank of New York, though these gold holdings do not have any official or legal linkage to the supply or value of national currencies and are thus not technically monetary reserves.