Let's a review a little bit
of what we've gone over. And I think it helps to see the
whole process again, just so it really sinks into your
brain and I've drawn the banks in a different arrangement
this time. But just as a review, this
is a bank with a little bit less reserves. The green right here
is their reserves. It could either be deposits at
the federal reserve or these could actually be federal
reserve notes-- and we all know that as dollars or cash. This is another bank with
slightly more reserves. And just like I said in the last
video, I'm drawing the reserves at the top of the asset
side now so that we can compare it directly with the
demand deposits or the liabilities of this bank. Most banks have other
liabilities, but I've just assumed that all of them
are demand deposit. That's this magenta
square here. And of course their equity
is the blue right there. Let me make sure I have it. That's their equity. And of course if these are
either federal reserve notes or these are deposits within the
reserve bank, those are of course liabilities for the
reserve bank itself. So let me draw a line
from there to there. This is a liability for
the reserve bank. If these were deposits, if these
were essentially demand accounts with the reserve
bank, then we could even divide them up a little bit and
separate-- OK, this guy has this much-- I don't know
if you can see that. That color's not so good. This guy has this much. This guy has this much, but if
these are all federal reserve notes, they kind of all come
out of the same bucket. What we learned in the last
video is that the federal reserve-- they don't say,
we want the money supply to be X or Y. They always talk about in
terms of interest rates. They always say, our target
interest rate or the federal reserve rate is now
going to be X. Let's go over our mechanics a
little bit more on how open market transactions help to
make those rates happen. So let's say that on day one
or before the fed does anything, this bank has a little
bit extra reserves, this bank has a little
bit less reserves. So there's a couple things that
this bank could do with these extra reserves. It could either do some more
lending-- so it could actually-- because it's
reserve-- let's say it's at a 20% reserve ratio. This ratio to this is 20%. And it can be as low as-- it
would feel comfortable being at a 15% reserve ratio. So roughly a fourth of its
reserves could be used for doing something else. And what could it be used for? So let's say this portion of its
reserves could be used for something else. Well, it could lend them
to another bank who maybe needs reserves. So that could be this
right here. This bank maybe wants some
reserves and then it would add it up on here. The last video, I filled in the
reserves down here, but actually they're not replacing
other assets. They would have actually just
been added to the balance sheet of the bank. So I should have drawn them on
top and I'll do that a second. But the other option that this
bank could do is that they could actually do
more lending. Since the reserve ratio is
higher than they want, they can actually create checking
accounts like we saw on the last couple of videos. With that said, let's say that
this guy wants to borrow some. This guy's willing to lend some,
although that's not his only alternative. He could create checking
accounts essentially with it and do some more lending
with it. And let's say in this reality
right now given how much reserves are on the banking
system at the current rate-- let me write that right here. The current rate is 6%. Now the federal reserve
says, you know what? I would like to expand
the money supply. And they don't say
it directly. They don't tell us in
our newspapers. They don't make a press release
saying, we would like the official M1 value of the
money supply to go from $15 trillion to $20 trillion. They don't say that. They say, we are going
to lower the federal funds rate to 5%. So let's say they want a federal
funds rate-- they are setting to be 5%. The governors of the federal
reserve bank sit together and Bernanke comes out and says,
we're lowering the federal funds rate to 5%. So what that 5% percent
means is that their target rate is now 5%. So this is a target. So what they're saying is, we
are going to perform open market transactions in such a
way that now when this bank offers money to this bank it's
going to reduce its rate from 6% to 5%-- or another way to
put it, they're going to do open market transactions or
operations in such a way that the demand might also go down
for the reserves so this guy might be willing to pay less for
borrowing from this guy; instead of being willing
to pay 6%, he'll be willing to pay 5%. Remember, on any transaction,
both people have to agree on it. So how do they do that? And I think we've we're
reasonably familiar with the mechanics now. So what the federal reserve
could do is they can print some notes. Those are assets because
they haven't done anything with them yet. And then there's a corresponding
liability. I'll do that in a slightly
different shade of green. These are notes outstanding,
right? See, I should've done all this
in this darker shade of green. These are the liabilities. The light green are the assets,
the notes themselves. And what the federal reserve
does-- because they don't want to become an insolvent bank. They want to buy the most
liquid, safest assets out there and it actually makes a
lot of sense and we'll touch on this in a lot of
different ways. What they say is, we're going to
take this money and inject it into the system by buying
treasuries with it. And they could be buying those
treasuries from your grandmother, they could be
buying it from China, they could be buying it from Russia,
they could be buying it from me, they could be
buying it from my uncle. Regardless of who they buy it
from-- let's say they buy it from someone in the U.S.
so that we don't get confused right now. Let's say they buy
it from my uncle. So this is my uncle. Let me see if I can draw him. He's holding a treasury right
now-- an IOU from the government. That's what he has. He wasn't willing to sell it
before, but let's say the federal reserve has printed
more money and he's like, well, I'm not going to sell it
now, but if someone's willing to offer me a little bit more
money for it, maybe I'm willing to part with
my treasury bill. So the federal reserve-- and
he doesn't know that he's selling it to the
federal reserve. He just sees selling it to
market, the same way that when you buy a stock, you don't know
who you're buying it from or who you're selling
it to and all that. So all of a sudden someone goes
out there and is willing to pay a slightly higher price
for these treasury bills, these IOUs from the government
and he's like, oh, fine. Yeah, that's a good price. I'm going to sell them to
whoever's buying it. It turns out that it's actually
the federal reserve that's buying it. So the federal reserve all of a
sudden has-- my uncle would be a big time operator if
the federal reserve only bought from him. He would have to have hundreds
of billions of dollars of these things. And he doesn't have
his IOU anymore. What does he have right now? That IOU is now exchanged for
a dollar bill or hundreds of billions of dollar bills or
reserve deposits at the federal reserve-- all the same,
but just to keep the abstraction solid for right now,
we'll keep it in terms of dollar bills. So his IOUs he's sold
in exchange for these dollar bills. And what does he do with them? This is hundreds of billions
of dollars. He's not going to stuff it
all into his mattress. He's going to deposit it into
the banking system. So maybe he gives a little
bit to this bank up here. This is a slight mistake that
I did in the last video. I was adding it below,
but it's not replacing other assets. It's new assets. So let's say he put some of it
here-- my uncle after he sold his treasuries. Let's say he put some of it in
this bank-- or maybe it's a bunch of people's uncles
and they all don't go to the same bank. Let me do that in a slightly
different shade of green, just so you know this is--
I'll do in blue. Just so you know, this is a new
deposit, but it's close enough to green that I think
you get the idea. And of course, he has an off
setting-- his checking account if he didn't have one already. Now he has one so their
liabilities increase a little bit. So a couple of things
will happen. Just in terms of how does this
affect the rate that they're charging to each other? Well, now all of a sudden, this
bank's reserve ratio's gotten a little bit better. His assets and his liabilities
increased, right? His assets increased by the
amount of my uncle's deposit, but so did the liabilities
because he's had the demand deposit. But it came in a ratio
of reserves to demand deposit 100%. So this would have improved
his reserve ratio. If you now take the ratio of
this height to this height, it's not going to improve
a little bit, right? So now he doesn't need money--
this bank doesn't need money as bad in order to improve
its reserve ratio. And likewise, this bank now
even has an even better reserve ratio. He already had more reserves
than he needed and now he got even more. He has an even better
reserve ratio. So now this guy's demand for
reserves is a little bit lower and this guy's supply
of reserves is a little bit higher. So this guy's only going to be
willing to pay a little bit less for new reserves
from this bank. And this guy, he's willing
to charge less now because he has more. He doesn't know what
to do with it. He doesn't know enough people
who want to borrow more money so he wants actually lend off
some of his reserves. So just by increasing the
supply of reserves and decreasing the demand of
reserve, the current rate-- if the fed does this
appropriately-- will go to 5%. And let's say it only went to
5-1/2%, then the fed will keep doing this and then
it'll go to 5%. If it goes too far, if it goes
to 4-1/2%, maybe the fed will reverse the transaction. The fed will actually go
out there and sell these treasury notes. But I also want to make it clear
that the point of this-- although it does affect the
interest rates and that's what the federal reserve always talks
about in terms of their target rates-- the net effect
of injecting more reserves into the system is it increases
the lending power of the bank. And if we have, let's say, a
10% reserve ratio, every dollar that is injected into
the banking system right there, that bank can then
do $10 worth of lending. Let's say that bank lent
it all to this bank. Let's say he lends all of that--
so now this turns to an asset, which is a loan
to this bank. So this bank then has--
this isn't a demand deposit anymore. This is now a loan
from this bank. He has more reserves now. That's his reserves. I shouldn't be doing it
in that purple color. I should be sticking to green. But the bottom line is, wherever
those reserves are, doesn't matter which banks they
sit in, but every dollar of that increased reserves
enables $10 of lending, right? This bank now can create $10 of
checking accounts through lending and so even though the
federal reserve talks in terms of interest rates-- and I'll
talk a lot about why they're more focused on interest rates
than absolute measures of the money supply-- even though they
talk in terms of interest rates, by performing these open
market transactions that in effect lower the interest
rate by increasing the amount of reserves out there, they're
actually increasing banks' lending capacity. So the amount of reserves--
that's base money-- or you could almost view it as the
liability side of the federal funds, the reserve deposits. That's base money. That's M0. And you get a multiplier effect
for M1, which is the amount of demand deposits
because in this bank it got more reserves and then it can
create a bunch of demand deposits like we learned
earlier. So by saying that they're
lowering the rates, they're essentially saying that they're
going to perform open market transactions that will
inject reserves into the banking system, which will
allow them to keep their reserve ratios in line, but
make a lot more loans. So significantly increase the M1
and then the other, looser, the broader definitions
of money supply. I will see you in
the next video.