Editing Federal Reserve (section)

==== Interest on Reserves (Demand) ====
[[File:INTEREST ON RESERVES1.png|thumb|330x330px|Interest on Reserves Diagram]]
Another way to affect demand is by changing interest on reserves. Until 2008, the Federal Reserve did not pay interest on reserves banks held with them. First authorized by Congress 2006 with implementation scheduled for 2011, the program was fast tracked in response to the crisis. This was pursuant of Fed policy: buying up toxic assets while minimizing the effect this would traditionally have had on general liquidity. Fed officials feared the federal funds rate would dip below their target and cause price instability. <blockquote>To avoid this outcome, the Fed "sterilized" the effect of liquidity injections on the overall economy: It sold an equal amount in Treasury securities from its own account to banks. Sterilization offset the injections' effect on the monetary base and therefore the overall supply of credit, keeping the total supply of reserves largely unchanged and the fed funds rate at its target. Sterilization reduced the amount in Treasury securities that the Fed held on its balance sheet by roughly 40 percent in a year's time, from over $790 billion in July 2007 to just under $480 billion by June 2008. However, following the failure of Lehman Brothers and the rescue of American International Group in September 2008, credit market dislocations intensified and lending through the Fed's new lending facilities ballooned. The Fed no longer held enough Treasury securities to sterilize the lending.


This led the Fed to request authority to accelerate implementation of the IOR policy that had been approved in 2006. Once banks began earning interest on the excess reserves they held, they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market, which would drive the fed funds rate below the Fed's target for that rate. When the Fed stopped sterilizing its liquidity injections, the monetary base (which is comprised of total reserves in the banking system plus currency in circulation) ballooned in line with Fed lending, from about $847 billion in August 2008 to almost $2 trillion by October 2009. However, this did not result in a proportional increase in the overall money supply (Figure 1). This result is likely due largely to an undesirable lending environment: Banks likely found it more desirable to hold excess reserves in their accounts at the Fed, earning the IOR rate with zero risk, given that there were few attractive lending opportunities. That the liquidity injections did not result in a proportional increase in the money supply may also be due to banks' increased demand to hold liquid reserves (as opposed to individually lending those excess reserves out) in the wake of the financial crisis<ref>The Effect of Interest on Reserves on Monetary Policy, Federal Reserve Bank of Richmond, 2009[https://web.archive.org/web/20231004123632/https://www.richmondfed.org/publications/research/economic_brief/2009/eb_09-12#:~:text=On%20October%2013%2C%202006%2C%20the,%2C%20to%20October%201%2C%202008. https://web.archive.org/web/20231004123632/https://www.richmondfed.org/publications/research/economic_brief/2009/eb_09-12#:~:text=On%20October%2013%2C%202006%2C%20the,%2C%20to%20October%201%2C%202008.]</ref></blockquote>In the graph, IOR allows the Fed to place a floor on the federal funds rate (the horizontal line in the supply curve), because banks have little reason to lend at rates below the rate of interest they receive on their reserve balances. The rate is determined by the Board of Governors.