To steer the economy, the Federal Reserve sets a target for the federal funds rate, which is the rate that banks charge one another for overnight loans. Until 2008, the Fed influenced the federal funds rate by adding or subtracting reserves from the banking system. It did so through the buying and selling of bonds, which is known as open market operations. When a bank buys Treasury bonds from the Fed, it pays with some of its reserves, which are held in what’s basically a checking account at the Fed. Before 2008, when the Fed soaked up reserves from the banks by selling bonds to them, banks that were short on reserves would have to go into the federal funds market and borrow them, driving up the interest rate on those interbank loans. That uptick would cascade through to higher interest rates across the economy, cooling growth and inflation.
The global financial crisis of 2007-9 changed all that. The Fed heavily bought bonds from banks to drive down long-term interest rates, paying as usual by crediting their accounts with more reserves. The banks became so flush with reserves that no banks needed to borrow them, and the federal funds rate fell to effectively zero. To put a floor under the federal funds rate, the Fed began paying interest on banks’ reserves, reasoning correctly that no bank would lend to another bank at a rate lower than what it could earn on reserves kept at the Fed. (It later added a subfloor, the overnight reverse repurchase rate, but I’m trying to keep this simple.)
None of this was hidden from view. Journalists, economists and, of course, Fed officials have been writing about it since 2008. Here’s a quote from an article that appeared in The Times on Oct. 7, 2008:
To pay for its burgeoning responsibilities, the Fed has no choice but to keep printing more money. To prevent that flood of new money from reducing the central bank’s overnight interest rate to zero, the Fed also announced on Monday that it would start paying interest on the excess reserves that banks keep on deposit at the Fed.
Paying interest on reserves allows the central bank to set a floor on interest rates and retain at least some control over monetary policy.
That’s how things have worked ever since, even though it wasn’t until 2019 that the Federal Open Market Committee formally declared that it “intends to continue” with a policy based on ample reserves in the banking system.
Textbooks, however, continued to explain monetary policy the old way for more than a decade, including in editions that were issued long after the Fed’s policy changed. Some mentioned that the Fed had begun paying interest on reserves but made it seem like a secondary issue when it was actually the Fed’s primary way of steering the economy. Some authors seemed to be hoping that the Fed’s new system was just temporary and thus ignorable.
In 2020 economics educators got a strong nudge in a working paper by Jane Ihrig, an economist at the Federal Reserve Board, and Scott Wolla, an economic education official at the Federal Reserve Bank of St. Louis. Their title was “Let’s Close the Gap: Revising Teaching Materials to Reflect How the Federal Reserve Implements Monetary Policy.” They analyzed the newest editions of textbooks as of the first quarter of 2020.