by Bill O’Grady

This week, we continue our discussion on trade by examining the reserve currency issue.

What is the reserve currency?
When a country runs a trade surplus, it creates excess saving that must be either invested overseas or held as foreign reserves.  If a gold standard is being used, the excess saving/foreign reserves can be held as gold (or other precious metals).  In theory, reserve managers can hold just about any asset as foreign reserves.  However, if the ultimate goal of generating saving is to build the productive capacity of the economy, then the best foreign reserve assets should be safe and easily convertible, with broad acceptability in markets.

Here is an example we often use to describe why the reserve currency is important.  Imagine that a chocolatier in Paraguay wants to purchase a ton of cocoa beans.  He calls a dealer in Côte d’Ivoire for a price; the seller offers $1,800 per ton.  The buyer in Paraguay notes he does not have U.S. dollars but does have Paraguayan guaraní.  The seller does not want the Paraguayan currency because it would limit his purchases to Paraguay because the guaraní isn’t widely accepted.  The seller in Côte d’Ivoire would be able to buy a wider variety of goods (or have wider avenues for investment) from selling cocoa if he receives U.S. dollars instead.

So, how does the chocolatier in Paraguay get dollars?  The most efficient way would be to export chocolate to a U.S. buyer, then use the dollars he receives to buy cocoa beans from Côte d’Ivoire.  Because the reserve currency has widespread acceptance, non-reserve currency nations have an incentive to run trade surpluses with the reserve currency nation to accumulate the reserve currency, which allows them to pay for imports from around the world.

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