Total of a country's gold holdings and convertible foreign currencies held in its banks, plus special drawing rights (SDR) and exchange reserve balances with the International Monetary Fund (IMF).
Foreign Exchange reserves are maintained primarily to protect a country’s domestic currency from losing its value or, in other words, to avoid a currency crisis.
Just like other goods, a country’s currency can lose its value when demand for it falls or when there is excess supply of it. Such a situation may arise when investors do not want to stay invested in that country and want to transfer their funds out of that country or from the currency of that country. For example, suppose due to any reason a foreign investor wants to sell out his equity holdings in Indian companies and want to transfer these funds to the USA. In this case, he or she would convert the Indian rupees received by selling the equities into US dollars. If a large number of investors do this simultaneously while the reverse (fresh investments by foreign investors into Indian equities) is not happening, it will lead to a fall in the value of the rupee. Which is to say, it would lead to the depreciation of the Indian rupee against the dollar and there is a net outflow of dollars. Sometimes this depreciation (or need for devaluation) could be large in magnitude. Such instability in exchange rates and loss of confidence in the currency have an effect on the economy. So to avoid such sudden changes and to maintain confidence in the currency, reserves are maintained.
