Reserve currency is held by the government for international payments. Mostly it is reserved in shape of
gold or silver but it can be reserved in dollars or other form of currency and this is called Bretton Woods
system. But since 1973, it was not allowed to convert any currency into gold. The basic aim of the
reserve currency is to support the currency of its own country. For example, Mexico introduced pesos
for its people but repurchases them in shape of dollars, Euros and other currencies. A country can make
reserve in shape of gold or any other precious metals as its reserves.
With the help of Bretton Woods agreement, U.S dollars were converted into pound sterling as reserves
in 1945. At that time U.S dollar was the powerful currency of the world and it was converted into gold
but it was eliminated in 1973. Then dollar was not the only reserve currency but euro became more
popular reserve currency but debt crises made it weakened. Now Yuan is becoming more popular
reserve currency because many reforms are in process. Now China has opened the restrictions on
currency and made its entering and leaving freely and due to this reason market has become more
liquid. Now many reforms have been done in all fields. Now it can be said that China is the largest
creditor and will become largest exporter in the world.
Monitory policy can affect foreign currency reserves. If a country wants to increase value of its currency,
it can repurchase its currency from reserves. When demand will be high, the value of the currency will
be high but this scheme will be beneficial if the economy will be strong. So exchange rate may be fixed
by the country and this will lead the value either low or high. A country can also monitor other reserve
currencies of the world and can check how it is affected? Inflation can hit the value of currency. For
example, when inflation will be high, the value of the currency will be low but you can take control
on the value of currency with the help of monitory policy. A country can hold currency as reserve for
number of reasons. China, Russia and Japan are the largest holders of reserve currency.