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Finance and capital markets
Course: Finance and capital markets > Unit 8
Lesson 2: Quantitative easingFed open market operations
Fed Open Market Operations. Created by Sal Khan.
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Sal, you mentioned in2:34the government will go to the bank and buy treasuries which is very safe. In your other videos, you mention treasuries are loans that the gov't agree to pay back in a later date. In this process, the fed is printing out more money to lower the short term interest rate and buying back its' own treasury (or future loan obligations)? Isn't there inheritantly wrong with this picture? Doesn't this devalue the dollar/currency?(8 votes)
No, printing money is not the same as dollar debasement. When we talk about the monetary unit "losing value", in effect we are saying this monetary unit buys fewer products and services (a gallon of milk for example is no longer $3 it is now $5, so it takes more $$ to buy the same items). In other words, monetary debasement is equivalent to inflation.
Now inflation does not automatically occur with money printing; inflation is not the direct effect. There is an intermediary step which is the direct cause of inflation. Again, inflation is a general rise in prices, so let's ask, why do prices go up? What causes a rise in prices? Prices go up because businesses raise them. Well, why do and under what conditions do businesses raise prices? When demand for their product or service is strong enough given their potential output level and a business feels safe in raising their prices in an effort to increase their profits, then prices go up (this isn't the only reason prices can go up, but it is the one relevant to our discussion). If economic conditions are poor, a business is just looking for more sales at the current price. They will just be happy to have more sales, and they won't want to jeopardize the sale by raising the price, at least not significantly. So printing money can help the economy by increasing sales without prices necessarily rising.
Ultimately dollar debasement depends on the economic conditions within which the money printing is occurring. If money printing continues indefinitely, eventually enough of it will result in a great enough increase in demand where businesses feel secure in raising prices. It is important though to see this intermediary step toward inflation, the real cause of inflation; it wasn't the money printing that caused the rising prices, it was businesses who felt safe and secure to choose to raise them, and businesses will not necessarily feel this way just because more money is in the system and they are receiving more sales. A business will want to be close enough or at full production before it says, "Okay, we're near or at production capacity, we think we can get more money for the same level of production thereby increasing our profits, so let's raise the price." The objective of the money printing is to try and get demand high enough to support businesses so they are at or near full production. Once this is achieved, the money printing should stop (as long as the aggregate demand is self-sustainable) otherwise inflation/dollar debasement will result. But until a business gets to or is near full production, inflation won't result (at least not to any level worth worrying about). Rather money printing and proper distribution of this printed money will actually improve the economy with little to no negative side effects. Hopefully this helps.(20 votes)
Why does the government want the short-term interest rates to go down? Is it so banks will borrow more?(6 votes)
No, the Fed lowers interest rates to encourage lending. The Fed thinks that it's a good idea to encourage more investments in projects that only make sense at a lower interest rate. Giving the banks more cash so that inter-banking lending is easier means that loans out to non-bank entities will be easier too. (Personally I think the Fed is insane, and is creating more malinvestment bubbles.)
Sal discusses this in the "Banking 16: Why target rates vs. money supply" video.(6 votes)
- What is the relationship between the Federal Funds Rate and the Treasury Yields? Why has the Treasury yield curve fallen in an era of Open Market Operations? I would have expected demand/rates would increase with greater government demand (unless non-government market participants moved away from treasuries in favor of equities?) Links to any videos/articles would be appreciated. .(5 votes)
The Federal Funds Rate is the very shortest term bond yields. All other bond yields are an extension of these yields.
Remember that the price of bonds and interest rates move in the opposite direction. When demand for a particular bond rises, yields fall because people are willing to earn less interest for the taking on the same amount of risk.(1 vote)
on minute2:50, Sal says US government buys treasury securities, or other kind of securities...
this means treasury bonds, that they issued themselves right?
what other kind of securities is Sal referring to?
Also, who are those people government buys securities from?(3 votes)- At3:13, Sal mentions that the Fed buys Treasuries from banks in order to inject money into them. Does this mean that the Fed will receive the coupon payments and principal payment from these Treasuries - i.e., will the government be paying itself interest on money that it loaned to itself?(3 votes)
- The Fed receives coupon and principal payments from the treasury on any treasuries it holds. But it doesn't really matter because if the Fed ends up with any profits at the end of the year, those profits are returned to the government.(2 votes)
I'm not sure what treasury securities are?(2 votes)
They are loans that the government takes from the public. In turn, the government promises a certain rate of interest. What the government promises is usually trustworthy, "guaranteed" in financial understanding or "risk free." So for your own investments you could buy treasuries. You can check this out by visiting the government website, they educate the public in detail: http://www.treasurydirect.gov/(2 votes)
As Sal mentioned before, many US Treasuries are in hands of foreign countries or institutions, such as China. If the Federal Reserve were to buy many of these treasuries, wouldn't it mainly stimulate the Chinese economy (in this example) instead of the US economy? This seems quite inefficient.(2 votes)
No. It would stimulate the US economy. If the Federal Reserve prints dollars and uses them to buy treasuries from China, then China ends up with dollars. There is only one thing that China can do with the dollars, and that is buy stuff from the US.(2 votes)
- How and who decides the interest rates?(2 votes)
- The Fed decides on a target for the overnight lending. They can't mandate the banks use a certain overnight rate. The Fed just prints money until the rates drop to what they want.(1 vote)
To who does the fed give the money? To the treasury? How do the treasury give the money to the banks? They give it for free?(1 vote)
The Fed buys government bonds with the money, so the money goes to the sellers of those bonds. The sellers are banks.(2 votes)
Why can't the government ask Federal Reserve to create money to increase its (government's) spending? Why does the Federal Reserve has to buy securities through the open market operations to increase money supply? If government wants money, the Fed can just print money and send it to the government. Since, government creating money is legal. Why this process is not used to increase money supply?(1 vote)- Because if they did that then very quickly the value of the money would collapse, because everyone would realize the government was just printing pieces of paper willy-nilly. Pieces of paper have no intrinsic value. The value of the currency depends on confidence among the people who use it.(2 votes)
2:34Video transcript
Let's say we have two
banks, bank A and bank B, and you might already know
that banks, all banks, lend out the great
majority of the money that they get in as deposits,
but they keep some of the money as reserves. One, just in case their
depositor comes and hey, can I have some of my
money back and two because the central bank, the Federal Reserve, says you have to keep a certain amount of your deposits in reserve. There is a reserve requirement,
but you can imagine over the course of doing transactions, thousands of transactions
a day, millions maybe, maybe bank B more of
its depositors come by and say hey, give me
some of my deposits back. Obviously he's lent out a
lot of that money and so he starts running low on reserves. Maybe bank A, the depositors haven't asked for the money or for
whatever reason Bank A is sitting on a lot of cash. In this situation, what
you're going to have happen is bank A is going
to lend some reserves, is going to lend some cash to bank B. This is lending some
cash and they'll charge an interest rate for lending that cash. Maybe it will be 5%
interest and that won't be 5% per day and usually
these loans are on a per day basis and then
the next day it'll be renegotiated on a per
day basis, but it's not 5% per day. It'll be 5% per year, so
it will be a much smaller fraction, but usually as
I mentioned this lending takes place on a per day basis. We'll say hey, this is
your cash for just tonight. If you need it for the
next night, we'll talk again and maybe it will
be another 5% or maybe the interest rate can change again. Let's say the Federal
Reserve is sitting over here and for whatever reason wants to stimulate the economy. This is the Fed and they want to stimulate the economy so they start
printing some money. I should do money in green. The Federal Reserve
here, they're starting to print some money and they
want to do two things. They want to inject this money into the banking system which
essentially, hopefully, will find its way into
the economy and they also want to lower the
interest rate, especially the short term interest rate. This overnight borrowing. Remember this is the annual interest rate, but this is an overnight loan. Overnight loan. When I talk about the
short term interest rate, I'm talking about the
interest rate on loans that are made over very
short periods of time. What the Federal Reserve
will do is what's called open market operations. They will go to the market and maybe directly to these banks
or some other banks and they will buy treasuries. They will give this
money to the market and in exchange, they will
usually buy treasury securities. Sometimes something
slightly different, but usually very safe
securities and maybe it's temporarily buy. I'll take about repurchase
agreements in the future. What happens is that this
cash goes in the hands of the people who just sold the treasury securities and they have
to deposit it in banks. They might deposit it
in this bank over here. They might deposit it
in this bank over here or other banks, but the
net-net effect is that there's more cash now in the banking system. If there's more cash
in the banking system, this guy right over here needs less. This guy needs less cash,
so it lowers demand. It lowers the demand for
cash and then this guy has more to give, so it raises supply. Raises the supply
because some people maybe just took some of this cash and deposited with them. If it raises the supply
of cash and this guy needs it less, then the
rate to borrow this cash is going to go down. Maybe instead of 5%, it's goes down to 4%. What that would do is it would lower the short term of the yield
curve, the short end of the yield curve. Let me draw a yield curve right over here. This is maturity on
this axis, maturity, and this is yield. Let's say the yield curve
before looked like this. Let's say it looked like this where this right over here is 5% and this overnight. Overnight. This might be yield on, I
don't know, one year debt. This might be yield on, I don't know, maybe it's five year debt. Whatever, I could keep
going, but by doing this open market operation,
the Fed was able to do both of its goals. It was able to inject
cash, printed cash, into the economy and it's also able to lower the interest rate. It took it from being 5% to down to 4%. Now because of this open market operation, the Fed, the yield curve
might start to look something like that.