Cecil Bohanon and John Horowitz: For better or worse, here’s how the Fed operates

A few weeks ago, Ball State’s Economics Club took 10 undergraduate students on a spring economic field trip to St. Louis. The group visited a social service agency, two universities, the City Museum and a St. Louis Cardinals baseball game (sadly, the Redbirds lost).

The group also visited the St. Louis Federal Reserve Bank (Fed). We learned that, before 2008, the Fed mainly managed monetary policy through open-market operations. Since 2008, the Fed primarily manages monetary policy by paying interest on excess reserves held by member banks.

The money supply is the cash the public holds, plus their deposits in checking accounts at commercial banks, plus other liquid deposits. Open-market operations are when the Fed increases or reduces the nation’s money supply by buying or selling government bonds.

Suppose the Federal Reserve buys $1 million in U.S. government bonds. It issues the bond owner a check drawn on the Federal Reserve Bank for $1 million. The former bond owner deposits this in her checking account, and the money supply rises by $1 million. Moreover, the bank that received her deposit can lend a portion of this newly created money, further expanding the money supply.

Curious students often ask where the Federal Reserve Bank gets the original million dollars. The answer is that the Fed creates the money out of thin air! That’s the incredible power of a Central Bank.

In 2008, the Federal Reserve started paying member banks interest on the excess reserves they hold at the Federal Reserve. Two things happened. First, it shored up the banking system. The Fed injected new reserves into the system and paid the banks interest if they sat on the money with the Fed. And banks did just that. As someone said, it made banking easy. Where does the Fed get the money to pay the interest? Same as above, out of thin air.

But second, and as important, this interest rate became the Fed’s go-to tool to manage the economy. When the Fed raises the interest rate paid on bank deposits, banks are less likely to lend excess reserves, which cools down the economy. When the Fed lowers the interest rate on bank deposits, banks are more likely to lend reserves, which revs up the economy.

Has it been more effective? Our recent inflation experience says not particularly. But it is a change our students and readers should know about.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.