What is the purpose of reserve requirements set by a central bank?

The purpose of reserve requirements set by a central bank is fundamentally about ensuring banks hold a minimum amount of reserves. This is crucial for maintaining the stability and liquidity of the banking system. By requiring banks to keep a certain percentage of their deposits in reserve, either in their vaults or at the central bank, it ensures that they have enough funds available to meet the withdrawal demands of their customers. This helps prevent situations where a bank would become illiquid and unable to honor withdrawal requests.

In addition to providing a cushion against unexpected withdrawals, these reserve requirements play a significant role in the overall control of the money supply within the economy. When these requirements are adjusted, it can influence how much money banks can lend out, thereby affecting interest rates and overall economic activity. However, the primary function of reserve requirements is to ensure that banks remain solvent and capable of fulfilling their obligations, thus protecting the interests of depositors and the stability of the financial system.