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Current time:0:00Total duration:13:22

Video transcript

let's do a little review of what the Fed Funds rate was that's a little bit too thick the Fed Funds rate and then we could move into something that you've probably heard in the same context and they're often confused and that's the discount rate so the federal funds rate and then there's the discount rate and they are related and they kind of do move together but they are pretty different in their actual implementation so the federal funds rate this is a target rate this is the target rate at which the Federal Reserve wants banks to lend to each other so let's say that I have and I won't draw the balance sheets every time now let's say I have Bank one C this is Bank number one and this is Bank number two and let's say this Bank over here has a surplus of reserves I was already using green but I'll do that in gold just so we can reminisce about the gold standard so let's say it has a surplus of of reserves and bank two needs them right and let's say right now that Bank 1 is willing to lend it to Bank two if Bank two pays Bank 1 a 6% overnight rate and let's say that the the Federal Reserve they say you know what that's above our target rate we want banks to lend to each other for lower interest rate so we want to do open market transactions or open market operations to lower this rate and the mechanics that they do it by let's let's draw the Fed's balance sheet I'll do the Fed over here I'll do them in magenta that's too thin okay nope wrong tool there we go so that's half of it and then this is the other half so let's say that this is the feds current assets and in a couple of videos I'll actually show you what the Fed's balance sheet looked like before all of this craziness started what it looks like now but that's the current the federal the Federal Reserve's assets this is their liabilities and then their liabilities are going to be a little bit smaller than their assets and they have a little equity although their equity is a little different than traditional equity there really isn't a lot of upside you just get a dividend on it but we won't go to the details there but the mechanism that the Fed uses to do these open market operations is they essentially print money so the Federal Reserve will do is they will create some notes or some actual reserves so these are Federal Reserve notes or as we know them the dollar bills that are sitting in your in your wallet or the things that could be converted to dollar bills that are sitting in your bank account the bits and bytes in some computer database someplace and they can't create out of thin air they have to have an offsetting liability and their offsetting liability our Federal Reserve notes outstanding Federal Reserve notes outstanding all right this is just saying hey we issue this so if someone comes back to it we have this liability and this is issued even though these Federal Reserve notes I'll circled in yellow are issued by the Federal Reserve Bank this is a Federal Reserve they are backed by The Full Faith and Credit of the US government and we've talked a lot about what that means but needless to say we're just going over the mechanics so what they'll do is they'll take these dollars now and they'll use these dollars to go buy Treasuries from people out in the world it could be me it could be my my my grandfather it could be even some of these banks and so let's say that there's you know right now somebody is holding a Treasury let me see if it's if it's me I hold a t-bill I hold a t-bill the Federal Reserve will use that money let's say I own a ton of tea bills I'm the richest man in the in the country it even be China China a lot of t-bills they buy the t-bill so then this becomes this asset is no longer Federal Reserve notes it's now a t-bill I'm writing tea bill over that and then I'm no longer holding a tea bill right because I sold it to the Federal Reserve Bank I don't know I sold it to the Federal Reserve Bank I just sold it in the market I don't know who bought it might have been another guy might have been another country but it happened to be in this case the Federal Reserve Bank and now I'm holding reserves I'm holding money as we know it I'm holding a Federal Reserve Note and what am I going to do with that Federal Reserve Note I'm going to deposit it in banks right and so I'm going to take this Federal Reserve Note let's say I have a couple of bank accounts or I you know whatever just the sake of simplicity I deposit some of it in this bank account let's say I deposit some of it in this bank account just for simplicity so what happens now now this guy has more notes to lend out and this guy needs less write so demand has gone demand has gone down this guy needs less so demand has gone down from this guy and supply has gone up from this guy and we know that if you need something less but people have more of it the price of buying it or borrowing it is going to go down so this guy has more of it and this guy needs it less all of a sudden this guy is not willing to pay 6% to borrow it and this guy is actually more desperate to offload some of these reserves and get some interest on it so this guy is going to lower the rate he'll charge and this guy's going to lower the rate he's willing to pay and maybe it goes down to 5% and the Federal Reserve can keep buying or selling Treasuries to adjust what this happens it could do the opposite if they said wow you know rates are a little bit too low let's say whatever happens rates are at 3% and the Federal Reserve doesn't like that and wants to raise the federal funds rate which is the target rate that banks lend to each other then they could do the opposite thing they could take this tea bill right this was a tea bill and there you'll sell it right so they'll take this tea bill and they'll sell it to someone else and you know maybe this guy right here so this guy he's got a dollar bill so dollar bill actually I won't draw it there his dollar bills are going to be sitting at one of these banks let's say his dollar bills are sitting at one of say he's got a couple there in a couple there so when the Federal Reserve sells this tea bill to this guy this guy might do a wire transfer to that party or check or it doesn't matter but either way you look at it these reserves disappear and they go back into the Federal Reserve and when they go back into the Federal Reserve they offset this liability and then the currency essentially disappears but the real result is that all of a sudden then demand would have gone up because there'd be few fewer reserves in the system demand goes up and then the supply would have gone down because there's also fewer reserves in the system and now this guy he's like well I have less to lend out I need more interest in order for me to lend it out and this guy says wow I'm more desperate than ever to borrow some reserves I'm willing to pay more and so the rates will go up to 4% now all of this works well assuming a world where banks are willing to lend to each other at some rate there's some rate at which you know this guy says you know what I'm willing to lend to this guy because I know he's going to pay me the next day and it's just a matter of just supply or demand and these tend to be overnight loans they tend to be very short-term loans so they tend to be very very safe but what happens in a world what happened let me draw the same two banks I think I over drew so this is Bank number one and this is Bank number two and Bank number one had more reserves Bank number two has fewer Bank number two needs reserves let's say people are worried about Bank number two all of their depositors are starting to get scared and they're starting to pull their reserves out right and we all know that these banks don't keep enough reserves to fulfill all of their deposits actually let me draw a bank number twos balance sheet let's say this is Bank number twos balance sheet they have they have some equity hopefully they'll have some deposits let's say all of these are deposits they'll have some deposits they have to keep some reserves right so that's an asset and depending on their their reserve requirements but they'll have summers in case people want to take out their money from their checking account and then the rest of these are assets that they invested in and the bank makes money by making more money on these assets than it has to pay out an interest it makes money on that spread now what happens if this Bank its condition starts to get a little bit weak people start to get afraid and the deposits start to start to people go to their ATMs start pulling their money out and and if anything maybe they'll start depositing it into a safer bank or just stuffing it under their mattresses right this Bank says oh no all of a sudden I have a liquidity issue because sure if maybe that much people withdraw their money I have enough reserves to pay that but then then if another guy comes along then that's going to deplete my reserves and then when the next guy comes along I'm not going to have any reserves left and there's going to be a full all-out panic when I you know I told this guy that I could give him his money on demand and all of a sudden if I can't give him on demand then we're gonna have this huge banking panic and then everyone else is going to want their deposits and then I'm going to have this huge liquidity crisis in a normal situation like that I'd say hey Bank number one I need some reserves and just like I did in the first half of this video this guy would lend and you know this guy would lend reserves and then this guy would give this guy interest but what if this guy is scared of Bank number two - he's like wow that guy's in a tough situation he's paid to seeing a liquidity crisis I don't even know what his assets are worth maybe his assets are actually shrinking and that's been happening lately maybe he made a bunch of bad mortgage loans I don't want to lend to this guy and this guy becomes a pariah of the banking community no one wants to lend to this guy but at the same time it's in no one's interest for there to be a run on this Bank because if this guy can't pay one of his depositors and that's this is kind of a prime weakness of the of a fractional reserve system is if there's just one weak link in the banking system and people lose confidence maybe this guy was the only bad bank out there and people start taking all their money out the first guy who can't get his money back he's going to call up the press and say my god the banks aren't good for the money and maybe everyone there's around all the banks but people don't know which banks are good which ones are bad so to prevent this the Federal Reserve has something called the discount window so let me draw the Federal Reserve's balance sheet again and the Fed the discount window is essentially a lender of last resort to the banks so there's some type of you know federal funds rate let's say the federal funds rate is at 6% and in a normal environment this guy would lend to get that guy at 6% but let's say that's broken and this guy is really desperate he can actually go to the Federal Reserve he can well he can go to the Federal Reserve and borrow directly from the Federal Reserve so once again these are the assets of the Federal Reserve these are assets these are the liabilities this is the equity of the Federal Reserve and the Federal Reserve in this situation now they'll print notes so Federal Reserve notes or reserves either way and these are the notes outstanding liability and they will lend it to this guy the lend these notes to this guy and in exchange this guy has to give some collateral to the Federal Reserve so let's say he had some other assets here that are hard to sell right that he couldn't find like where he didn't want to sell them in a hurry so he'll just keep it as collateral with the Federal Reserve and these are called repurchase transactions it's essentially just your collateralizing alone and I'll do a whole video on what a repo transaction is but the big picture is this guy's desperate no one else is willing to lend the money so the federal funds rate is now a non-issue so he goes to the discount window and borrows directly from the Federal Reserve as a lender of last resort and the rate at which he borrows the interest that he pays this guy that is the discount rate so that's the rate that a bank pays to the Federal Reserve when it can't borrow from another bank overnight and in general the discount rate the discount rate tends to be higher than the federal funds rate in fact it always is right because you don't want people if the discount rate was less than the federal funds rate that you'd always have people using the discount window all of the time instead of using instead of borrowing from each other but we'll see in future videos when times get tough this gets used a lot more historically the discount rate was about a percent higher than the federal funds rate to encourage people to lend to each other or borrow from each other but in the recent past the spread has gone down and now all of the rates are almost zero but we'll go with that in more detail but it's a key different intial when the federal reserve cut talk talks about setting rates they're usually talking about setting the federal funds rate and the discount rate usually moves down with it but it's always going to be a little bit higher than the federal funds rate this is for lending of last resort this is for everyday borrowing between banks to make sure that everyone has the reserves they need or they don't have too much and they can get interest on it anyway see in the next video