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Chapter 5: The Fed on Steroids

We have a fractional reserve banking system in
the United States, meaning that banks are required to
keep a fraction of their assets in reserve. Banks lend
money from their excess reserves. The Fed influences
a bank’s liquidity by encouraging an increase or a
decrease in banks’ excess reserves by raising or
lowering bank’s required reserves. The greater the
excess reserves, the higher the bank’s liquidity and the
more money it can lend or invest in the markets. When
interest rates are near zero, the Fed can no longer lower
interest rates (unless for negative interest rates),
making monetary policy ineffective. There are reasons
during recessionary times that people may not borrow,
despite the bank’s efforts to lend more money. Keynes
called this a liquidity trap.

POLICY CHANGES BY THE FED
There have been significant changes in Fed
policies since the financial collapse of 2007-2008. First,
Congress granted the Fed permission to pay interest on
a bank’s reserves, which is problematic because it
discourages public offerings. Faced with a choice of
making loans to the public or collecting risk-free
interest from the Federal Reserve, banks often chose the
risk-free option.

Second, since the financial collapse of 2007-2008,
the Fed now grants loans to entities other than
commercial banks or the federal government. The Fed
has been lending money to favored businesses while
refusing loans to others.
Currently, the federal government has no authority
over monetary policies, including agreements with

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