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Essentially, bank reserves are an IOU of the Central Bank to the commercial banking system.

As Wikipedia notes, they are deposits held by banks in accounts at the Central Bank (The Fed), plus currency that is held in the bank’s vault.

Reserves differ, however, from overall deposits.  The level of overall deposits in the system is typically much larger than the level of reserves.  This leads to a problem, however, because banks must use reserves when settling payments with other banks but often don’t have enough reserves on hand to settle large payments or outflows of money.

The Federal Reserve in the US solves this problem by flooding the system with reserves during the business day and then taking them back out at night.  Removing the reserves at night allows the Fed to hit its targeted interest rate on short term loans, either between banks or between the Fed and the banking system.

Here is a quote from the Federal Reserve paper  ”Divorcing money from monetary policy“:

 … reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.


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