Finance and capital markets
- Banking 1
- Banking 2: A bank's income statement
- Banking 3: Fractional reserve banking
- Banking 4: Multiplier effect and the money supply
- Banking 5: Introduction to bank notes
- Banking 6: Bank notes and checks
- Banking 7: Giving out loans without giving out gold
- Banking 8: Reserve ratios
- Banking 9: More on reserve ratios (bad sound)
- Banking 10: Introduction to leverage (bad sound)
- Banking 11: A reserve bank
- Banking 12: Treasuries (government debt)
- Banking 13: Open market operations
- Banking 14: Fed funds rate
- Banking 15: More on the Fed funds rate
- Banking 16: Why target rates vs. money supply
- Banking 17: What happened to the gold?
- Banking 18: Big picture discussion
- The discount rate
- Repurchase agreements (repo transactions)
- Federal Reserve balance sheet
- Fractional Reserve banking commentary 1
- FRB commentary 2: Deposit insurance
- FRB commentary 3: Big picture
More on the mechanics of the Federal Funds rate and how it increases the money supply. Created by Sal Khan.
Want to join the conversation?
- Correct me if I am wrong: our economic system and the health of it is based upon debt? For every $1 printed, the banks can make $10 worth of loans. So paper is printed out of thin air and entities go in debt to satisfy the banking system? Is this system the best solution?(15 votes)
- Are the IOUs the only way fed can inject money into economy? What happens in an ideal situation where the govt doesn't have any IOUs outstanding?(10 votes)
- their goal is to put cash in the supply so they really could invest in anything (bonds or stocks of public traded companies etc). during the stock market collapse they even bought some questionable assets from companies who needed cash to stop from failing.(6 votes)
- So, even if a bank's lending capacity is increased, what good does this do if the economy is so bad that no businesses want to borrow from them? Isn't that the condition we're in during a recession?(4 votes)
- That's why it's a crazy system. We fall down drunk on debt, and the solution is to raise the capacity of the banks to distill and distribute more 'alcohol.' Clue: the alcoholics (consumers/debtors) never gain, only the pushers (bankers) do.(3 votes)
- Could bank A and bank B use treasuries as reserves or do they have to use dollars (and gold)?
And I ask this why? :
Let's say bank A uses treasuries as reserves and they currently have a 10% reserve ratio. Say also that the Fed decides to lower the Fed Funds Rate. Say that they (the Fed) print some money and use them to buy treasuries from bank A. So what happens is bank A exchanges its treasuries for an equal (maybe a little more) amount of money, so their reserve ratio hasn't changed. Right?(3 votes)
- The reserve rate of 10% means you have a value of actual money equaling 10% of you're investments or loans. Treasuries are investments, so they could not be held as reserves.(3 votes)
- When the fed increases the money supply and the banks get more assets, what is stopping them from then going and making more loans and as a result decreasing their reserve ratio again? Wouldn't the banks just end up back at the same point where they've made loans until they reach the required reserve ratio again and the demand for money is where it was before the fed intervened?(3 votes)
- exactly, the banks reserve ratio returns to normal so they are able to lend more money, and since the interest rate they had to pay for overnight lending has decreased so does the interest rate we have to pay for our loans, spurring us on to borrow more and expand the economy.
i think..(4 votes)
- When Bank A makes an overnight loan to Bank B, where does Bank B get the money to pay the interest on that loan, considering that the reason it took the loan in the first place was because it needed money to stay above the reserve ratio?(2 votes)
- Bank B was short of cash but but it still has plenty of assets. Tomorrow or the next day or the next day some loans will get repaid or some deposits will come in.(3 votes)
- Is the interest rate that banks typically use when lending to each other less than the rate they use when lending to an individual or other institution? And if so, what incentive do banks have to lend to each other?(2 votes)
- In my understanding the rate is usually lower. An example is the LIBOR rate which is the average rates that a group of banks in London use to lend to each other. When you get a variable rate loan, like a credit card or something, the rate might be specified as LIBOR plus some. Loans to individuals are almost always at higher rates because the're generally more risky.
Banks loan to other banks for two main reasons: they have more money laying around then they need for their reserves and as quid pro quo for business relations. In the first case they get to make some interest on money that would have otherwise been sitting there doing nothing. Banks are generally some of the least risky institutions to lend to and the loans are very short term (just a day or two). So the risk to the lending bank is very small for the interest earned. The second improves the business relations between banks because the lending bank might need a loan tomorrow if enough of its customers pull money out that day.(3 votes)
- At9:34, Sal mentions that though the Fed may have increased the reserve supply, effectively lowering the current federal funds rate, it may not fall to the desired rate right away. In Sal's example, the rate only drops from 6% to 5.5% and not to the ideal 5%. What is the time scale for this change in rate - days, weeks, months? I understand that the goal of their actions is to increase lending power of banks rather than just adjust the current rate and the rate is just a measure of that lending power; I'm just curious how soon the Fed could see the rate change in order to adjust their reserve supply to meet their ideal current rate.(2 votes)
- It seems like Treasury bills are where everything starts. Where do these Treasurys come from? Does the U.S simply print them and sell them out to buyers promising interest? Why do they have interest associated with them?(2 votes)
- Treasury bills (paid back in less than a year), notes (paid back over several years) and bonds (paid back over 30 years) are all loans to the United States government.
When the government spends money over what it takes in in taxes, it must get that money by going into debt by selling bills, notes and bonds to anyone willing to loan the money to it.
To get this borrowed money, the government must offer something more than simply repaying the borrowed money, just as when you borrow money from a bank to buy a car, the bank is going to charge you interest for using its money. In order to borrow money from anyone but a personal friend, you have to pay interest on what you borrow.
If the government didn't offer interest, nobody would lend it the money it needs.(3 votes)
- Currently, the Fed Funds rate is 0.25% I believe. What motivation do banks have to loan money at this rate to other banks when they could demand much higher interest rates on the open market? Or is the point of the FF target rate simply to inject cash into the economy so banks are able to make loans in general?
Also, Sal mentioned that the Fed wants to remain a safe and solvent bank by buying the safest asset (i.e. treasuries). However, as of late, they have been purchasing 80 B/month of MBS/CDO/CBOs which are a very risky assets. What will happen when the Fed is forced to write these securities down as there is no (and never will be IMHO) a market for them?(2 votes)
- The fed funds rate determines the shortest term lending rates and the shortest term any bank will lend for is overnight. At the end of any given day, if a bank has excess funds, it will try to lend them out overnight to banks that need them. There is essentially no credit or inflation risk in an overnight loan between two banks, therefore there should also essentially be no interest on these loans. But, the interest rate is 0.25%, how come? The Fed actually manipulates the fed funds rate higher. If the market was to determine what the shortest term interest rates were, the rates would naturally fall to 0%. So, this is a pretty good deal if you're a bank with extra money at the end of the day. Yes a bank could lend at higher than 0.25% over a longer period of time and they will do so if there are credit worthy borrowers. But if they have excess funds at the end of any day, the will try to lend those out to other institutions at 0.25%.
Also, there is no solvency constraint on the Fed. They literally have an unlimited balance sheet. Also, what makes you say there is no market for MBS and CDO's? There was a time in 2008/2009 when there literally wasn't a market for them, but the Fed stepped in and put a floor under it. The market for structured products is alive and well and has been fully valued for quite some time now.(2 votes)
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.