How the Fed Worked: Before the Great Recession

In the United States, the Federal Reserve controls the supply of money. This makes it a pretty massive player in the US – and world – economy.

The Fed can use the money supply and interest as tools to influence aggregate demand. But how the Fed does this has changed since the Great Recession. We’ll start by covering how it was done prior to 2008.

First, let’s talk about how the Fed can change the federal funds rate – the overnight interest rate for when banks lend money to each other. Banks are required to keep a certain amount of money in reserves. Prior to 2008, there was not much incentive for bank to keep an excess of reserves. But if that number got too low, a bank might need to borrow from another bank to meet the minimum requirements. This borrowing and lending of reserves between banks established the federal funds rate.

But how was the Fed involved? The Fed was buying and selling government securities with banks in what’s known as “open market operations.” This practice allowed the Fed to influence the federal funds rate.

Typically the Fed would be trading Treasury bills (or T-bills). If the Fed wanted to lower the federal funds rate, they’d buy more T-bills from banks to increase their reserves in an expansionary open market operation.

Think through what happens to an economy if banks have more in reserves thanks to an expansionary open market operation. Federal funds rates are lowered. Banks have more money with which to work. Do they lend more to each other? What about to customers? And what happens when money becomes cheaper for customers to acquire?

Of course, the federal funds rate is not the only interest rate! There are student loan rates, auto loan rates, mortgage rates, and so on. But, at least in theory, all of these rates move together. In practice, the connections between rates can be stronger or weaker, but you get the general idea.

When the Fed lowered the federal funds rate, it stimulated aggregate demand by making it easier for people to get mortgages, start a new business or invest in an existing one, etc.

Interestingly, when the Fed chair announced an intended change to the federal funds rate, the rate would often adjust before the Fed even began trading T-bills to meet the new target! The simple act of announcing a change could have a big effect. Communication is another tool that the Fed has in its arsenal to influence the economy.

Of course, both communication and open market operations are only two of many tools at the Fed’s disposal. And The Fed must continually evolve its approach as economic conditions change. Now that we’ve covered some of the important tools that the Fed used to influence aggregate demand prior to the Great Recession, it’s time to move on to post-2008 procedures in the next video.