As a keen student of the Great Depression, Federal Reserve Chairman Ben Bernanke became concerned when short term interest rates such as the federal funds rate fell below 0.5 percent in late 2008 as the Fed responded to the financial crisis. Bernanke recognized that with interest rates already so low, there was little room for the Fed to decrease them further. What steps could the Fed take to deal with what appeared to be a looming liquidity trap?
A number of academic economists suggested that the Fed commit to increasing inflation in the future by promising to create new money far into the future. Then, even if nominal rates could not fall below zero, real rates of interest (nominal minus expected inflation) could be negative. However, since the Fed is responsible for maintaining a low inflation rate, this was not an ideal policy.
The Fed decided to begin paying interest on bank reserves. Although there were several reasons for this policy, one reason that the Fed advanced was that this would put a floor on market interest rates. After all, if banks could earn, for example, 0.5 percent on their reserves, they would not lend those reserves out at lower rates to other banks or make loans at lower rates. The Fed had found a new tool to manage an economy with low interest rates.