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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
When the Federal Reserve does traditional open-market operations, what they do is the Fed over here will literally print money. So it prints money. It doesn't necessarily have to be cash, it could be electronic money. And it uses that money to buy usually short-term treasury securities in the open market. That's why it's called open market operations. So in exchange it gets treasury securities. Now, the whole purpose of this, it does increase the demand for treasuries, and, therefore, increases the price on treasuries and lower the interest rate. But the main point is it takes this printed money, and it puts it in the banking system. Because it buys treasuries just from people, or from banks, or institutions, and then those people take that cash, that they just got for these treasuries, and they'll deposit it in banks. So they'll go and they'll deposit it in, maybe, Bank 1 over here, then over here in Bank 2. And since there's more money in Bank 1 and Bank 2, you have the supply of money going up, and also the demand for reserves is going up. This cash right here, these are reserves. So you have the demand for reserves going down. Maybe before this money entered the system, maybe Bank 2 is running low on reserves. But now people have deposited money in Bank 2, so Bank 2 doesn't need it as much. And if you have the supply of money going up, you have the demand for money going down-- where in particular I'm talking about reserves. I'm talking about base-money right over here-- then the overnight borrowing rate between banks will go down. The price of money will go down. And that's what the federal funds rate is. It's the target rate. So I'll say fed funds rate. It's the target rate that the Fed sets for the overnight borrowing of reserves between banks. That's the federal funds rate, and it will go down. And that's how the Fed tries to set the federal funds rate. Now, fast forward to a situation like we are right now. And the federal funds rate is already at 0, but the Fed still wants to pump more money into the economy and it wants to do it in a more directed way. So now what it's doing, it's still printing money, but it's using that money to buy other things. It could buy longer-term debt. So it could buy longer duration treasuries. So things that are maybe going to, maybe 10-year treasury bonds, or further out than even that. Or it could even buy completely different assets. It could maybe buy mortgage backed securities. And the point here isn't just to increase the money supply. The point in quantitative easing is, maybe, to kind of smooth over what's happening in certain parts of the market. So if they think that there's a logjam in the mortgage backed security market, that's why they're participating there. So this right over here, that is quantitative easing.