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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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Video 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.