When the Fed buys bonds, what happens to its reserves?

When the Federal Reserve buys bonds, it increases its reserves. This process works through the mechanism of open market operations, where the Fed purchases government securities from banks or financial institutions. When these bonds are bought, the Fed credits the reserve accounts of the selling banks with additional funds.

As the banks receive payment for the bonds sold, their reserves rise, resulting in an overall increase in the amount of reserves held in the banking system. Higher reserves enable banks to lend more, which can have an expansionary effect on the economy. This action by the Fed is often aimed at lowering interest rates and stimulating economic activity when necessary.

In contrast, if the Fed were to sell bonds, reserves would decrease, as banks would pay for those bonds with funds that they previously held in reserves. The concept of the Fed's intervention in the bond market is crucial for understanding how it influences monetary policy and the liquidity in the banking system.