Banking 15: More on the Fed funds rate

let's 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 you can either be deposits at the Federal Reserve or these could actually be Federal Reserve notes and we all know that is as dollars or cash this is another Bank with slightly more slightly more reserves and just like I said in the last video I 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 and this that's this magenta square here and of course their equity is the blue right there make sure I have it that's their equity and of course either if these are either Federal Reserve notes or these are 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 so this is you know this is a liability for the Reserve Bank this is liability if I if these were the if these were deposits if these were essentially demand accounts with the Reserve Bank then you know we could even divide them up a little bit and separate okay this guy has this much and if you can see that that color is not so good this guy has this much this guy is this much but if these are all Federal Reserve notes and they kind of all come out of the same bucket and what we learned in in the last video and is 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 and so 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 of extra reserves this Bank has a little bit less reserves so there's a couple of things that this Bank could do with these extra reserves it could either maybe make do some more lending so it could actually it's reserved maybe it's let's say it's that I don't want to get too specific with the numbers let's say it's at a at a 20 percent reserve ratio this ratio to this is 20 percent and it it can be as low as a you know it would feel comfortable being at a 15 percent reserve ratio so roughly 1/4 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 want some reserves and then it would add it up on here I don't know the last video I I filled in the reserve down here but actually they're not replacing other assets they would have actually just been added to the balance sheet at the bank so I should have drawn them on top and I'll do that in a second but the other option that this Bank could do is that they could actually do more lending since the reserve ratio was higher than they want they can actually create checking accounts like we saw in the last couple of videos but with that said let's say that they want to you know this guy wants to borrow some this guy's willing to lend so I'm all the best not his only alternative he could do some more 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 systems at the current rate let me write that right here current rate 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 directly they don't tell us you know in our newspapers and it maker press release a we would like the official m1 value of the money supply to go from 15 trillion to 20 trillion dollars they don't say that they say we we are going to lower the federal funds rate to 5 percent so let's say they want a federal funds rate let me write that Fed Funds rate they are setting to be 5 percent the federal the the governors of the Federal Reserve Bank sit together and Bernanke comes out and says we are lowering the federal funds rate from 2 5% so with that 5% means is that their target rate is now 5 percent so this is a target this is a target so what they're saying is is we are going to perform open market transaction in such a way that now when this bank offers money to this Bank is 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 in any transaction both people have to agree on it so how do they do that and I think we've reasonably filled up familiar with the mechanics now so the Federal Reserve could do is that they can print some notes they can print some of their notes those are assets cuz they haven't done anything with them yet those are assets and then there's a corresponding liability I'll do that in a slightly different shade of green there's a corresponding liability these are notes outstanding right which I should have done all of this in this darker shade of green these are the liabilities the light green are the assets the notes themselves and what the what the Federal Reserve does because they want to they don't want to become an insolvent bank so they want to do by the most liquid safest assets out there and it actually makes a lot of sense and well we'll touch on this in a lot of different ways but what they say is we're gonna 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 for me they could be borrowing it from my uncle regardless of who they buy it from let's say they buy it from someone in the US 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 this is my uncle he's holding a Treasury right now you an IOU from the government that's what he has he wasn't willing to sell it before but let's say the Treasury of sorry the Federal Reserve has printed more money and now the federal and he's like well you know I'm not gonna 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 my Treasury bill so the Federal Reserve and he doesn't know that he's selling to the Federal Reserve he just sees like it's selling into a market the same way that when you buy a stock you don't know who you're buying it from or who you selling it to and all of that so all of a sudden someone goes out there and is willing to pay a slightly higher price for these Treasury bills these I use from the government and he's like Oh fine yeah that's a good price I'm going to sell them to the 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 or reserve deposits at the Federal Reserve all of the same but we'll just to keep the abstraction solid for right now we'll keep it in terms of dollar bills so his IOUs he sold in exchange for these dollar bills and what does he do with them this is hundreds of billions of dollars he's not gonna 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 and this is what I a slight mistake that I did in the last video I was adding it below but it's not replacing other assets it's a new assets so let's say he put some of it here my uncle did after he sold his Treasuries and let's say he puts some of it in this Bank or maybe it's a bunch of people's uncle's 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 it in blue just you know this is like a new deposit but it's close enough to Green that I think you get the idea and of course he has an offsetting his checking account if you 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 how does this affect the rate that they're charging to each other well now all of a sudden this banks reserve ratios 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 at a ratio of reserves to demand deposit 100% so this would have improved his reserve ratio if you now take if you now or take the ratio of this height to this height it's not going to improve right so now he doesn't need money this bank doesn't need money as bad in order to improve it's a reserve ratio and likewise this bank now even has an even better reservation he already had more reserves than he needed and now he got even more he has even even better reserve ratio so now this guy's demand for them for reserves is a little bit lower and this guy's supply of reserves is a little bit higher so this guy is 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 cuz he has more he doesn't know what to do with it he can't he you know he he doesn't know enough people who want to borrow more money so he wants to actually lend off some Mis reserves so just by increasing the supply of reserves and decreasing the demand of reserves the current rate if the Fed does this appropriately will go to 5% and let's say it only went to five and a half percent then the Fed will keep doing this and then it'll go to five percent if it goes too far four goes to four and a half percent 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 make you clip make it clear that the point of this although it does affect the interest rate 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 you inject every dollar that that the that is injected into the banking system right there that Bank can then do ten dollars worth of lending and let's say that bank lends it all to this bank let's say he he lends all of that so now this turns to an asset which is a loan to this Bank so this Bank then has he borrowed he hasn't 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 shouldn't to be sticking to green but the bottom line is wherever those resort reserves are it doesn't matter which banks they sit in but they enable every dollar of that increased reserves enables ten dollars of lending right this Bank now can create ten dollars of checking accounts through lending and so even though the 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 lowering the by performing these open market transactions that 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 it's or that you could almost view it as the liability side of the 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 loan so significantly increase the the m1 and then the other loser the broader definitions of money supply I will see you in the next video