How the Fed Worked: Before the Great Recession

The Federal Reserve is one of the most powerful players in the economy, because it controls the supply of money. And through that control, it influences aggregate demand in the economy. Sometimes the Fed wants to increase aggregate demand, and at other times, decrease aggregate demand. But how does it do this? Well, the Fed uses the money supply and interest rates to affect the amount of loans and credit. Let's briefly recap how the Fed did this in the old days, before 2008.

Now in the old days, the Fed typically conducted monetary policy by targeting the federal funds rate with open market operations. What's the federal funds rate? Well, the federal funds rate is the overnight lending rate from one major bank to another. Yes, banks do loan money to each other. Recall that banks make money by taking in deposits and using those deposits to make loans. Banks cannot lend out all of their deposits, because they need some funds on hand to settle transactions with other banks, to give to customers, and also to satisfy the Federal Reserve which requires, by law, that banks hold a certain percentage of their deposits as reserves. Prior to 2008, the banks didn't have much incentive to keep excess reserves -- that is, reserves above and beyond what was required by law -- so the banks tried to keep reserve holdings relatively low. Sometimes banks found themselves with too few reserves to meet the requirements of their customers or of the Fed, so they borrowed reserves from other banks. Borrowing and lending of reserves in the federal funds market -- that established an interest rate, the federal funds rate.

And now we get to our second concept, open market operations. The Fed affects the federal funds rate by performing open market operations, and those we define as the Fed using its reserves to buy and sell government securities, typically Treasury bills. And the Fed is making those trades with banks. So if the Fed wanted to lower interest rates, it would buy T-bills from banks, thus increasing the supply of bank reserves. We call that an expansionary open market operation. The new reserves would allow banks to make more loans, thus stimulating the economy, making it easier to start or expand new businesses or easier to get a mortgage. This increase in reserves, it also would lower the opportunity cost of banks loaning those reserves out to other banks, and that, in turn, would lower the federal funds rate. Thus, prior to 2008, the Federal Reserve used open market operations to change the supply of reserves until the federal funds rate was more or less at the level the Fed wanted. This figure shows excess reserves prior to October 2008. Note that banks were typically holding about 2 billion dollars in excess reserves at that earlier period in time. By the way, if you're wondering, that big spike in 2001? That was a response to the terrorist acts of 9/11, when the Fed made tremendous amounts of emergency cash available to the financial system. Now, at that time, demand deposits in the system often were around $300 billion, so excess reserves were really quite small relative to deposits, less than 1%. Now, going back to the longer story, keep in mind that while the Fed has considerable control over the federal funds rate, there are lots of different interest rates in an economy. In theory, these interest rates to some extent move together, and they're affected by the interest rate the Fed does influence. In practice, those connections can be looser or tighter, and that will influence how good a job, or how exact a job the Fed does in steering the economy. How exactly does this work in practice? Well, the Fed Chair announces a change in the target federal funds rate. That signals the Fed will buy and sell T-bills until the federal funds rate adjusts to the new target. It's interesting, though -- usually the federal funds rate adjusted to the Fed's announced level very quickly, sometimes well before the Fed even conducted the open market operations at all. In fact, the Fed's communication is another important tool the Fed has to influence the economy. For instance, the Fed has very important psychological effects on the market, through its talk, its posturing, and its announcements. Of course, the Fed had other instruments to influence the economy before the Great Recession, but we're focusing on the most important tools. In summary, before the Great Recession the Fed usually changed the supply of bank reserves to affect interest rates and the money supply, and thus it could influence credit conditions and aggregate demand. That was then. Now, for our next video, we're going to consider the contemporary procedures.