The Federal Reserve - Buying and Selling Bonds

 When The Federal Reserve Buys Bonds, The Economy Grows But Inflation Increases

When the Federal Reserve buys bonds, it injects cash into the banking system, increasing banks' reserves (money in their vaults). If banks have ample cash, this liquidity — when banks own cash rather than valuable assets like loans or bonds — encourages them to compete fiercely for borrowers by offering more loans to households and firms. This intense competition and high supply of available credit (cash) drive down the price of a loan—the interest rate. As interest rates fall, borrowing becomes cheaper, stimulating both consumer spending and business investment. This increase in overall spending creates a higher demand for goods and services, leading companies to hire more workers, which in turn reduces unemployment and fosters economic growth. The primary trade-off for this stimulus is that the heightened demand across the economy can also lead to an increase in inflation.

When The Federal Reserve Sells Bonds, The Economy Shrinks But Inflation Decreases

When the Federal Reserve sells bonds, it drains cash from the banking system, reducing banks' reserves (money in their vaults). With less cash on hand (liquidity), banks become more cautious and households and firms compete to secure the few loans available. This reduced supply of available credit (cash) drives up the price of a loan—the interest rate. As interest rates rise, borrowing becomes more expensive, causing households and firms to take out fewer loans. Consequently, they spend less, and this decrease in spending results in less need for workers, leading to slower hiring or even layoffs. As unemployment increases, the economy slows down, with the intended trade-off being that the decrease in demand helps to lower inflation.