How the Fed Works: After the Great Recession

In response to the 2008 financial crisis, the Fed employed some new instruments and approaches to getting the economy back on track. In this video we explore three of these: quantitative easing, paying interest on reserves, and conducting repurchase (and reverse repurchase) agreements.

Let’s start by understanding quantitative easing — which occurs when the Fed swaps money for assets other than treasury bills. This allows the Fed to affect different, longer-term interest rates which impact different parts of the economy. Quantitative easing also increases banks’ supply of reserves, helping them meet all of their lending requirements.

The second tool the Fed employed in response to the crisis is the ability to pay interest on reserves held at the Fed. Commercial banks can earn interest on reserves held at the Fed, and thus banks are incentivized to hold reserves at the Fed when they earn a higher rate of return from the Fed than market interest rates. By changing the rate of interest on reserves, the Fed can affect other short-term interest rates.

The third approach we discuss in the video is repurchase agreements and reverse repurchase agreements. A repurchase agreement is an overnight loan or swap of bank reserves for Treasury Bills (T-bills). A reverse repurchase agreement, for instance, implies that the Fed takes on reserves, and sends the other party T-bills. A reverse repurchase agreement decreases banks' and other financial intermediaries' cash liquidity, giving them a higher rate of return on T-bill holdings and discouraging their investment elsewhere.

The Fed used all of these tools and others when responding to the Great Recession, but it’s important to remember that monetary policy continues to evolve today as economic conditions change.