In the past, during the Bretton Woods system (an international monetary system formed after the Second World War), foreign exchange reserves were used by countries through their central banks to maintain the external value of their currencies at fixed rate. Subsequently, with the collapse of this system, the focus changed. Foreign exchange reserves are now generally maintained by countries for meeting their international payment obligations both short and long terms, including sovereign and commercial debts. Countries keep foreign exchange reserves for many reasons.
Foreign exchange reserves are used to finance imports and for intervention in the foreign currency markets during periods of volatility. It also helps in boosting the confidence of the market in the ability of a country to meet its external obligations and to absorb any unforeseen external shocks, contingencies or unexpected capital movements. Foreign Exchange held by central banks and other major financial institutions is used as a means to pay off international debt obligations, or to influence the exchange rate of their domestic currency. A large percentage of commodities, such as gold and oil, are usually priced in the reserve currency, causing other countries to hold this currency to pay for these goods. Holding currency reserves, minimizes exchange rate risk, as the purchasing nation will not have to exchange their currency for the current reserve currency in order to make the purchase. The most popular currency held in reserves is the U.S. dollar.
In the U.S.banks are part of the Federal Reserve System and it is required that a certain percentage of their assets be deposited with the Federal Reserve. The reserve requirements are established by the Board of Governors and by varying the requirements Feds are able to influence the money supply in the economy. Reserves also keep the banks secure by reducing the risk of default by ensuring that they maintain a minimum amount of physical funds in their reserves. This increases investor confidence and stabilizes the economy. In today’s world U.S. dollar is the primary reserve currency used by most countries. As a result, foreign nations closely monitored the monetary policy of the United States in order to ensure that the value of their reserves is not adversely affected by inflation.