So far we've talked about how
the Fed can control the money supply by performing these open
market transactions where they're buying and selling
Treasury securities. But you're probably asking,
when I read the newspaper headlines about all of this,
I don't hear about the open market transactions so much and
I don't hear about them buying treasuries so much. I always hear them setting the
Federal funds rate, or the discount rate, or
the target rate. And what do these words mean
and how do these relate to open market transactions? So that's what we'll try
to go over right now. So what we're going to focus
on is the target rate-- and then probably in the next video
or in a couple more videos, we'll focus more
on the discount rate. And they're two different
things, although they're often used in conjunction with each
other and they move in tandem, but let's focus on the target
rate because this is how the Fed, under normal conditions,
normally sets its monetary policy. So, the target rate. So just so you know the
definition, this is the rate that the Fed wants banks to lend
reserves to each other on a very short term basis--
so, overnight. What does that mean? So I drew two banks here-- and
I drew a little bit different than I normally do. The left-hand side
is the assets. The red box is the liabilities
and this blue over here, this is the equity. And the thing that I did
different is, every video so far, I've been drawing
the reserves on the bottom of the assets. And that actually made it a
little confusing when you compare the reserves to
the demand deposits. I'm assuming all the liabilities
are demand deposits-- that they're not
taking other types of loans. So these are all checking
accounts, all of this red area right here. So I actually finally figured
out that it would be easier to compare the reserve ratios if
I had it drawn side by side. So let's say this bank right
here-- these are its reserves in green-- and these could be
actual dollars, this could be actual cash that's sitting in
there in their vault, or it could be reserve deposits with
the Federal Reserve. They're really the same
thing and they can go back and forth. And I think that's kind of--
you understand that now. And just so you understand, this
asset is a liability of the Federal Reserve. It's roughly that much of it. So that's that. An asset for the bank, liability
for the Federal Reserve-- and this reserve for
this bank is a liability to the Federal Reserve. And if these were actually
cash-- if this was actually dollar bills and this would say,
notes outstanding-- if this asset is a demand deposit
account or reserve deposit account with the Federal
Reserve, then this would just say, reserve account
for bank B. With that said, so this bank,
just visually the way I've drawn it-- let me just
fill this in. I think looks nice when I
color in the squares. This bank-- its reserves just
the way I've drawn it are clearly-- its reserve ratio is
clearly lower than this bank because this is its demand deposits, this is its reserves. Let's say that this bank has
reserves-- I'm just eyeballing it-- looks like about if you
take the ratio of this height to this height, it looks like it
has reserves of maybe-- I'm just going to say 10%, while
this one looks more like it has-- I don't know-- closer
to 20% reserves. And now remember, banks-- we
talked about regulations, so there is some minimum reserves
that a bank needs to keep. And then, of course, even if
there were no regulation, a bank would want to keep some
reserves just in case some of these demand deposits-- people
want their cash, so you always want to keep some reserves, but
you don't want to keep too much reserves. Because what happens with
too much reserves? Reserves-- you don't get any
interest on a reserve account or on cash. And that's actually how the--
if you were curious how the Fed actually supports itself--
well, it gives these banks reserve accounts, which are
essentially checking accounts at the Fed-- and it gives
them no interest on it. It gives them no interest so
it has no interest on the right-hand side of their
balance sheets. So it pays no interest
on its liabilities. And its liabilities are these
things right here. It pays no interest on these
things, but it gets interest on some of its assets. So here I drew a little
bit of gold. This yellow part is
gold right here. Let me write that-- gold. This right here is gold and then
this brown color-- we'll assume that these are
treasuries, right? So if I have a government
treasury, it gives me some interest. So I'm paying no
interest if I'm the Fed. I'm paying no interest on these
reserve deposits or on these notes outstanding. And I get interest
on my assets. So that's easy money and it
actually turns out that what the Fed does-- and this is why
it's very ambiguous whether it's really independent of
the government or not. It is officially a private
institution, but it's a board of directors that's appointed
by the government and even more, this money that it makes,
any surplus money that it has after paying all of the
expenses of the Federal Reserve, it actually goes
back to Congress. So don't think that somehow
there's this private bank with this great money making scheme
because all the money goes back to Congress. Although that goes both ways. If for whatever reason, the Fed
were to do really stupid things and it were to become
insolvent, Congress is obligated-- we learned before
that these treasury notes are obligations of the
U.S. government. So it goes both ways. So even though it's officially
independent, it really isn't. It really is almost a part of
Congress-- or at least a part of the government. But with that said-- actually,
I should say part of the Treasury, not so much
part of Congress. I don't want to be technically
incorrect. But with that said, let's go
back to this example with these two banks. So this guy, he probably has
more reserves than he needs. And he doesn't like having too
much reserves because you don't get any interest on it. Let's say that this guy--
he wants 15% reserves. He figures that that's more
than enough that he needs. And this guy, he feels like he's
getting a little bit low on reserves. He would also like
to get to 15%. So this guy would like to
borrow this much money. Reserves would actually be
physical cash or reserve deposits with the Fed. And this guy, he has about
this much to lend. He has roughly about this much
right here to lend-- and so the obvious thing, since there's
only two banks in this universe, is that this guy
would lend to that guy, probably overnight because you
don't know what's going to happen tomorrow. Maybe some people are
going to want their money back, et cetera. So we're just lending
overnight. And if this guy still feels
comfortable with the situation, he can continue
that lending. This guy can renew his
lending and this guy will renew it-- whatever. You get the idea. So the question is, what
interest rate does this guy charge to that guy for lending
this little chunk of money? Let's just say right now, this
bank says, well, I'll charge you-- I don't know-- I'll charge
you 10% overnight. So it's not like you're paying
10% just for a one night loan. It's an annual rate of 10%. So overnight, you're paying
this to the 1/365 power or however many business
days there are. So it's actually a very small
amount of interest. These are kind of the annual rates if
this guy were to continue borrowing it overnight and
overnight for a whole year. With that said, let's say that
the Fed decides the money supply isn't big enough. That the Fed wants to expand
the money supply. So let's see what happens
in that situation. So what was that mechanism? So what the Fed does is,
it can print notes. Let's just say it's actual
physical cash. That's an asset that the
Fed is holding now. And of course it has an
offsetting liability now, which is notes outstanding,
right? And then what the Fed does is,
it uses these notes and it can buy treasuries, it
can buy risk free government debt, right? And it buys them in
the open market. That debt might be being
held by China. It might be being held
by your grandmother. It could be being
held by anyone. It might even be being held by
some of these banks, but needless to say, they take
this and they buy treasuries with it. So then that asset then turns
to treasuries on the Fed's balance sheet. But where did all that
cash go, right? Well, that cash will then go
to your grandmother who was holding the treasuries. And what is your grandmother
going to do with that cash? Well, your grandmother is going
to put that cash in their bank, right? And maybe they're buying it
from a lot of people's grandmothers. And so let's say some of the
grandmothers put the money in this bank. I'm trying to draw it. So this bank gets a little
bit more reserves. And then some of the
grandmothers put it in this bank over here, right? And so what happened? What was the net
effect of that? The government's balance sheet
increased a little bit. If you look at its total
assets, it's expanded a little bit. Or if you actually just look
at its total liabilities. Its balance sheet grew. It took on some treasuries-- and
we'll have a whole video on what the impact on treasury
interest rates that does. But in the process, when it
bought those treasuries on the open market, more cash
got deposited into the banking system. And this could be cash or it
could be reserves with the central bank. But now let's think about
this situation between these two banks. Now all of a sudden this bank
here needs less money, right, because he got some reserve
deposits from our grandmothers. And also, this bank-- maybe now
this guy went from 10%-- maybe now he has a 12% reserve
ratio because he got some deposits of actual cash. And maybe this guy went from 20%
to-- I don't know-- 22%. So now this guy needs
less money, right? His demand for money has been
lowered, or for cash has been lowered, or his demand for
reserves has been lowered. And this guy has even
more to lend, right? He already had a surplus and
now he has an even bigger surplus, right? So the supply of reserves
has increased in the banking system. The supply his increased from
the lending bank and the demand from the borrowing
bank has lowered. So now for this transaction to
occur, the demand has gone down, the supply has gone up. The price has got
to go down for a little borrowing overnight. And what is the price
of borrowing? Well, that's interest rates. So now for this transaction to
occur, all of a sudden maybe this guy needs it less, this
guy wants to lend even more because he has more. So now maybe this transaction
will occur at an 8% interest rate. And maybe the Fed has
a target rate of 5%. They want to see a reality where
this bank is lending to that bank at a 5% rate. So what would they do? Well, they would just keep
doing this process. They would issue a
little bit more. I realize I'm not going
to have time. But you see the process. They'd issue some more notes,
buy some more treasuries. Those notes would end up in
the banking system so the demand for overnight lending
will go down and there'll be more of those reserves
out there. So the rate at which
people lend to each other will go down. Anyway, I'll see you
in the next video.