The US Dollar (USD) stands as a cornerstone in the global financial system, being the official currency of the United States and playing a significant role worldwide. Its influence extends beyond the borders of the United States, serving as the 'de facto' currency in many countries where it circulates alongside local notes. The USD's dominance is evident as it remains the most heavily traded currency globally, commanding over 88% of all foreign exchange turnover. This extensive usage underscores its integral role in international trade and finance, with average daily transactions reaching approximately $6.6 trillion, as reported in 2022.
The USD's rise to prominence as the world’s reserve currency began in the aftermath of the Second World War, overtaking the British Pound. This transition marked a pivotal shift in global economic power dynamics, positioning the USD as a central player in international markets. The Federal Reserve (Fed), the central bank of the United States, shoulders the responsibility of maintaining the USD's stability and value through its monetary policies. These policies are guided by two primary mandates: achieving price stability by controlling inflation and fostering full employment.
To fulfill these mandates, the Fed primarily adjusts interest rates. When inflation exceeds its 2% target, the Fed responds by raising interest rates, thereby increasing the USD’s value. Conversely, when inflation falls below 2% or unemployment rates rise excessively, the Fed may lower interest rates, which can weigh on the Greenback. This strategic adjustment in interest rates is a critical tool for managing economic stability and ensuring that the USD remains a reliable currency.
In times of financial uncertainty, the Fed employs Quantitative Easing (QE) to inject liquidity into the financial system. This involves purchasing government securities to increase the flow of credit, which generally supports the USD. On the flip side, Quantitative Tightening (QT) occurs when the Fed ceases these purchases and does not reinvest in maturing bonds, a move that can impact liquidity and influence USD strength.
The USD's value is not tethered to any physical commodity but is instead a fiat currency whose worth is determined by supply and demand dynamics in the foreign exchange market. Its credibility is backed by the economic strength and creditworthiness of the US government. This trust in the US economy allows the USD to serve as a global reserve currency, held by central banks and financial institutions worldwide as a store of value and medium of exchange.
As a reserve currency, the USD facilitates international trade and investment, providing stability and predictability to global markets. Its widespread acceptance ensures that it remains a preferred choice for foreign exchange reserves, reflecting its enduring appeal and reliability.