Iam often asked whether the ongoing decline of the dollar implies that it can no longer serve as a reserve currency. My short answer is that most countries no longer hold dollars and other currencies as traditional reserves. The role of foreign exchange balances has changed from being short-term funds used to bridge export-import gaps to being long-term investment funds. In this new world, the dollar has shifted from being almost the sole “reserve currency” of many countries to being the primary “investment currency”, a role that it will continue to play far into the future.
A bit of history is helpful for understanding this evolution. For several decades after the second world war virtually all countries pegged their exchange rates to the dollar. From time to time, international differences in inflation rates or changes in trade preferences meant a country had to adjust the level of its dollar peg.
Under this pegged-but-adjustable regime, countries managed aggregate demand to keep imports about equal to export earnings. But for periods when imports temporarily exceeded exports, the country needed a stock of dollars or some other acceptable “hard” currency “in reserve” to pay for excess imports. The dollar was the most liquid of these hard currencies and so the reserve currency of choice.