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.