Banking 13: Open market operations

In the last video, I hinted that this was leading to a discussion of an elastic money supply-- or a supply of money that can change depending on the needs for the money. So before we go there-- and I took a little hiatus and told you a little bit about treasuries because that's a critical component-- let's review what the money supply even is. So there were two definitions. When we had originally talked about kind of an M0, I talked about just the gold reserves, but now we're going to expand that definition a little bit and I think you can tell-- I've got a lot of questions about this-- eventually getting off the gold reserve system and we will get there and we're kind of already there, but now I'll consider the base money supply as Federal Reserve deposits and notes. So in this reality that I just created, all of the Federal Reserve deposits have essentially been turned into notes, but if this bank didn't want all cash, it could have had some of this as just a checking account with the Federal Reserve bank. So a Federal Reserve note and a Federal Reserve deposit account is essentially the same thing. A note is just a little bit more fungible. You can hand it to someone and then they can hand it to someone else, while a checking account or demand account with the Federal Reserve bank, you have to kind of do a wire transfer or write a check, et cetera, but that is the base money supply. You could call that base money. And that's essentially the size of the liabilities of the Federal Reserve, in very broad terms. We'll go into detail on the actual Federal Reserve's balance sheet in the near future. So in this example right now, our base money supply is 200-- let's call it dollars now. Let's move away from gold pieces. Let's just say a dollar equals a gold piece for the sake of our instruction right now. So our base money supply-- and I'll call that M0. And that's the cash out there, which are the Federal Reserve notes plus the Federal Reserve demand deposits. So for example, this could have been just 100, like a checking account at the reserve bank and then this over here would have been a checking account instead. But it would still be considered part of the base money supply because if this bank, who had a checking account, says, I just want that in terms of notes, then the Federal Reserve bank will just issue notes and cancel out this checking account and it would turn back into notes. So they're equivalent. They're just a different way of keeping track of it. So that's the base money supply. Now, a slightly broader definition of the money supply. We could call this bank money. It's sometimes referred to as that and the formal definition is M1-- and that's essentially that notion that I went over I think almost 10 videos ago-- how much money do people think they have? And that's the amount of money in demand deposit accounts. So that in this case, that's this. So all the people in this bank, they think they have $100 there, right? That's $100 that they think that they have that they can write checks against. And then this bank also has another $100. And so the base money supply-- no, that's not right. No, no, sorry. They don't have $100. Why am I saying $100? Let's see. This bank had $100 in gold and it could lend out up to $200 in-- or it could put out up to $200 in checking deposit accounts. So it has $200. Right, that's what I was-- because we talked about earlier in the last video that we have a 50% reserve ratio, which tells us that if this bank has $100 in reserves, that it can essentially manage-- or it can issue $200 in demand deposit accounts. And we went over that many times on how that happens. And then this bank can do the same. It'll have $200 in demand deposit accounts. And so the total amount of money that people think they have, either in demand deposit accounts-- in this situation, I'm assuming that all of the cash is sitting in the reserve bank, although we do know that some of this is going to be sitting around circulating. But let's just say we live in a world where everyone uses debit cards all the time and no-one uses cash. And I think we're heading to that world very quickly. And as we'll see soon, that actually increases the money supply when you do that. But anyway, I don't want to go too technical just yet. But the M1, which is the total amount of demand deposit accounts in our universe, is $400. And this relationship makes a lot of sense because our reserve requirements are 50%. So we can kind of assume that banks tend to get as close to their reserve requirement as they can because they don't get interest on reserves. They make interest on the loans that they make against demand accounts. So if the reserve requirement were 10% and our base money was $200, we would probably see $2,000 in the M1 supply. So my question to you is-- and maybe you want to pause and think about this is-- how can the government or the central bank or, how can the economy, increase or decrease the money supply? And I guess the first question is, why would you want to increase or decrease the money supply? Well, let's say we're in this world already and we only have these two banks. And we have an M1 supply of $400. But let's say the economy expands. We have more goods and services that we're able to produce. Maybe we have immigrants come in so we have more labor. Maybe we have some innovative technology. Or maybe it's just seasonal. Maybe it's the crop planting season so a lot of farmers need their cash in order to hire people to plant the crops. So that's another time where you'd want more money. If you don't increase the money supply at those times when you have economic expansion or there's just more demand because of some type of seasonal fluctuaction-- if you don't increase the money, then what you're going to do is money's going to become more expensive. And I'll do a whole video on that so don't get too confused, but money getting more expensive means that interest rates will go up. And if money becomes too expensive, then some good projects, maybe some farmers who might have planted seeds, wouldn't be able to-- and so you would kind of restrict economic expansion. But we'll have a whole other discussion on when does it make sense to expand or contract money. Let's just talk now about how you would actually do it. So there's two ways. I just said if this reserve requirement were 10%, then these banks could create more checking accounts, right? They could lend out more money and create more checking accounts if the reserve requirement were 10%. If it was 10%, then you would have an M1 of $2,000, right? It would be 10 times this instead of two times this. And that is considered one of the tools of the Federal Reserve bank. Because we've said in the past that the Federal Reserve bank actually sets these reserve requirements. But the problem with that tool, if you think about it, is, if we made a reserve requirement 10%, right? And all of a sudden all of these banks started lending a lot more money and they only had 10%. The ratio of reserves to checking accounts were 10%. Think about what would happen if we wanted to raise the reserve requirement back to 50%. Then all of the banks-- they'd only have 10% reserves. How would they get back to 50%? All of these banks would have to either start selling assets or unwinding loans. It would be a very messy situation. If you were to lower the reserve requirement and then wanted to actually increase it again, you would actually make a lot of banks become undercapitalized, because most banks just operate right at where they need to. So you really don't want to mess around with this reserve requirement much. So the question is, if you're not going to change the reserve requirement, which is the ratio of the reserves to checking accounts, if you're not going to mess with that, the only other way that you can actually increase the number of checking accounts is if somehow you can increase the reserves. If you can somehow add some actual reserves over here. So my question is, how can you do that? Well, let's just say that-- we're hopefully already reasonably familiar with fractional reserve banking. So you might have seen it coming, that that also applies to the central bank. So the central bank right now, all of its deposits were directly backed by gold, 1:1. But there's nothing to stop this bank from also doing fractional reserve lending. And actually, the central bank has no reserve requirement. And that's because to some degree, it can always provide the liquidity because its notes are obligations of the government. So it can always tax more people to back up its loans. So what essentially the Federal Reserve can do is-- and this is the printing press of the base money supply that people talk about. But there's two printing presses. There's the base money printing press and then there's the leverage printing press. So if this increases-- well, I'll do a whole video on that another-- I don't want to get too technical because I realize I'm running out of time. So what the Federal Reserve could do in this situation is it can print some notes. So let's say it prints 100 of the notes, right, and those are just-- it literally just prints those dollars. It pays the treasury to print it for them, but it creates these notes and then of course, offsetting that is a liability, right? Notes outstanding, 100 liability. And then what it does is, it takes these $100-- I mean, these are literally dollar bills although it could be some type of demand account or whatever, but take these $100 bills that it printed and then it can buy treasury securities. So what happens if it takes these $100 bills and buys treasuries? And the treasuries don't have to be issued by the government anymore. Because whenever the government does issue treasuries, it's bought by just a bunch of people in the world. There's always a bunch of treasuries sitting out there as long as the treasury has some debt. So I was holding the treasuries and let's say that this is the central bank. I was holding some some of these government IOUs, right, that I had bought from the government. And the Federal Reserve, they have this $100. Let me draw that in green. So they just buy the treasury from me. Maybe I don't want to sell it at the current price so they have to pay me a little bit more than the current price in order for me to part with it-- and I'll do a whole other video on what that means and how that changes the yield curve and all of that, but I just want to get you to that base notion that the treasury essentially creates a notes outstanding liability and has an offsetting $100 of dollar bills that it just created or prints-- and then it can use those $100 bills to buy treasuries, or government IOUs, in the open market. And now what happens here? Well, these $100 bills, these are now treasuries. And my question to you is, what am I-- I was holding a treasury. It was sitting in my mattress. What am I now going-- now I don't have a treasury. I have $100. What am I going to do with that $100? Well, I'm going to deposit it in the bank. I'm going to deposit it in the bank. So this is me depositing my $100. Maybe I deposited it up here, but-- and my checking account grows a little bit, but what's the net effect? Now all of a sudden the banking system, the national banking system, has more currency, more dollar reserves, that apply to its reserve ratio. So now it got my $100 deposit. Now it can also do another $100 of lending. So I would have essentially increased the base-- so now the M0 goes from $200 to $300 right, because I have $300 in notes outstanding. And now my M1-- I took that $100 bill that the treasury gave me, deposited it in a bank account. Now I have a bank account that says $100 and then because of a 50% reserve requirement, the bank can issue another loan. I know it's getting messy. $400-- so essentially our M1 is now $600. So just like that, just by printing money and issuing treasuries, the central bank was able to increase the M1 by $200. I'll do more videos on this. I don't want to confuse you too much. See you soon.