In addition to foreign investment, the financial account of the balance of payments includes official reserves. Central banks, like the U.S. Federal Reserve System, maintain reserves of foreign currency or official reserves. The purpose of official reserves is to provide a stabilizing influence in the foreign exchange market. If a balance of payments deficit occurs, the Federal Reserve reduces its foreign reserves in order to zero out the balance. In the case of a balance of payments surplus, the Federal Reserve acquires additional foreign reserves to zero out the balance.
The United States is in the unique position of issuing the reserve currency for the majority of countries as most countries’ foreign reserve holdings are in U.S. dollars. The size of China’s and Japan’s official reserves has been a cause of concern for many in the financial community. As of 2015, these Asian countries have over $5 trillion worth of reserves. Some politicians, economists, and financial experts fear that if China or Japan were to reduce their dollar holdings, a collapse could ensue from a sudden increase in the supply of dollars in foreign exchange. Others contend that this would be every bit as harmful to the Chinese or Japanese, and thus they have little incentive to dump their dollars.
At the end of World War II, countries wanting to promote international cooperation and reduce the economic incentives for war met in Bretton Woods, New Hampshire, and established a fixed exchange rate system pegged to the dollar. The benefit of such a system was that businesses could easily engage in foreign trade without fear of losing money from fluctuating exchange rates. In addition, by pegging currencies to the stable dollar, foreign governments were responsible for practicing sound economic policies such as not creating inflation by recklessly printing currency. The Bretton Woods system was at first very successful, but by 1971 it had completely collapsed.
Today many approaches to exchange rates exist. Some countries let their currency float, others peg their currency to the dollar, and still others have unified under a single currency.
The United States and United Kingdom allow their respective currencies to float on the foreign exchange market, which means that they do not use official reserves to maintain exchange rates.
The benefit of this system is that it gives policymakers the ability to practice interest rate policies to encourage domestic growth or slow inflation without having to consider exchange rates.
China, Japan, and Hong Kong, however, peg their currencies to the U.S. dollar by actively trading their holdings of foreign reserves. This allows their respective countries to maintain a competitive advantage against others in the American market. China’s exchange rate policy is what keeps Chinese exports relatively cheap. Under a floating exchange rate, American demand for Chinese goods would force up the exchange rate and eventually make Chinese goods less desirable. The downside for China is that all of the money spent on stabilizing the exchange rate could probably be put to more profitable use. Also, managing the exchange rate means acquiring more and more dollar-denominated financial assets, which makes China vulnerable to America’s economic troubles.
The turn of this century saw another approach to exchange rate policy. Europe unified its economy under a single currency, the euro. France and Germany, for example, can now trade freely without regard to exchange rates. The advent of the euro created the world’s second largest currency after the dollar. For all of its benefits, the euro suffers a major drawback—individual countries can’t manage it.
Efforts by the central bank of a country to stabilize prices, promote full employment, and encourage long-run economic growth through controlling the money supply and interest rates.
In 2010, Greece suffered a severe financial blow when its sovereign debt’s credit rating was reduced. Unable to implement independent monetary policy, the Greeks have been forced to reduce their spending and raise taxes or risk default. The EU’s reaction to this crisis will either weaken or bolster the euro’s chances of becoming the dominant world currency.