Short Answer 
Reserves are funds that banks retain with the Federal Reserve to meet withdrawal demands and manage liquidity. Their purpose includes ensuring financial stability, providing a buffer for unexpected expenses, and aiding the Fed in controlling the money supply. Additionally, the Fed incentivizes banks to maintain reserves by paying interest, promoting liquidity and stability within the banking system.
Step 1: Understand Reserves
Reserves refer to the total amount of a bank’s deposits that are not lent out as loans, but rather kept safe with the Federal Reserve (the Fed). This amount is critical for banks as it ensures they have funds available for withdrawal and other requirements. Reserves are essential for maintaining liquidity and safeguarding against unexpected expenses.
Step 2: Recognize the Purpose of Reserves
The main purpose of maintaining reserves includes the following key points:
- Having funds available to meet customer withdrawals and payment demands.
- Providing a cushion for unforeseen financial situations.
- Helping the Federal Reserve control the overall money supply in the economy.
Step 3: Learn About Interest Payments on Reserves
The Fed pays interest on reserves as a way to incentivize banks to keep a certain amount of their deposits in reserve rather than lending them all out. By offering interest on these reserves, the Fed can help manage the money supply and ensure that banks remain liquid and stable. This process encourages banks to maintain necessary reserves while still earning income on their holdings.