Topic page
Banking and Money
- Banking 1
- Banking 2: A bank's income statement
- Banking 3: Fractional Reserve Banking
- Banking 4: Multiplier effect and the money supply
- Banking 5: Introduction to Bank Notes
- Banking 6: Bank Notes and Checks
- Banking 7: Giving out loans without giving out gold
- Banking 8: Reserve Ratios
- Banking 9: More on Reserve Ratios (Bad sound)
- Banking 10: Introduction to leverage (bad sound)
- Banking 11: A reserve bank
- Banking 12: Treasuries (government debt)
- Banking 13: Open Market Operations
- Banking 14: Fed Funds Rate
- Banking 15: More on the Fed Funds Rate
- Banking 16: Why target rates vs. money supply
- Banking 17: What happened to the gold?
- Banking 18: Big Picture Discussion
- The Discount Rate
- Repurchase Agreements (Repo transactions)
- Federal Reserve Balance Sheet
- Fractional Reserve Banking Commentary 1
- FRB Commentary 2: Deposit Insurance
- FRB Commentary 3: Big Picture
- LIBOR
Banking 14: Fed Funds Rate How open market operations effect the rate at which banks lend to each other overnight.
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- So far we've talked about how the Fed can control the money
- supply by performing these open market transactions where
- they're buying and selling Treasury securities.
- But you're probably asking, when I read the newspaper
- headlines about all of this, I don't hear about the open
- market transactions so much and I don't hear about them
- buying treasuries so much.
- I always hear them setting the Federal funds rate, or the
- discount rate, or the target rate.
- And what do these words mean and how do these relate to
- open market transactions?
- So that's what we'll try to go over right now.
- So what we're going to focus on is the target rate-- and
- then probably in the next video or in a couple more
- videos, we'll focus more on the discount rate.
- And they're two different things, although they're often
- used in conjunction with each other and they move in tandem,
- but let's focus on the target rate because this is how the
- Fed, under normal conditions, normally sets
- its monetary policy.
- So, the target rate.
- So just so you know the definition, this is the rate
- that the Fed wants banks to lend reserves to each other on
- a very short term basis-- so, overnight.
- What does that mean?
- So I drew two banks here-- and I drew a little bit different
- than I normally do.
- The left-hand side is the assets.
- The red box is the liabilities and this blue over here, this
- is the equity.
- And the thing that I did different is, every video so
- far, I've been drawing the reserves on the
- bottom of the assets.
- And that actually made it a little confusing when you
- compare the reserves to the demand deposits.
- I'm assuming all the liabilities are demand
- deposits-- that they're not taking other types of loans.
- So these are all checking accounts, all of this red area
- right here.
- So I actually finally figured out that it would be easier to
- compare the reserve ratios if I had it drawn side by side.
- So let's say this bank right here-- these are its reserves
- in green-- and these could be actual dollars, this could be
- actual cash that's sitting in there in their vault, or it
- could be reserve deposits with the Federal Reserve.
- They're really the same thing and they
- can go back and forth.
- And I think that's kind of-- you understand that now.
- And just so you understand, this asset is a liability of
- the Federal Reserve.
- It's roughly that much of it.
- So that's that.
- An asset for the bank, liability for the Federal
- Reserve-- and this reserve for this bank is a liability to
- the Federal Reserve.
- And if these were actually cash-- if this was actually
- dollar bills and this would say, notes outstanding-- if
- this asset is a demand deposit account or reserve deposit
- account with the Federal Reserve, then this would just
- say, reserve account for bank B.
- With that said, so this bank, just visually the way I've
- drawn it-- let me just fill this in.
- I think looks nice when I color in the squares.
- This bank-- its reserves just the way I've drawn it are
- clearly-- its reserve ratio is clearly lower than this bank
- because this is its demand
- deposits, this is its reserves.
- Let's say that this bank has reserves-- I'm just eyeballing
- it-- looks like about if you take the ratio of this height
- to this height, it looks like it has reserves of maybe-- I'm
- just going to say 10%, while this one looks more like it
- has-- I don't know-- closer to 20% reserves.
- And now remember, banks-- we talked about regulations, so
- there is some minimum reserves that a bank needs to keep.
- And then, of course, even if there were no regulation, a
- bank would want to keep some reserves just in case some of
- these demand deposits-- people want their cash, so you always
- want to keep some reserves, but you don't want to keep too
- much reserves.
- Because what happens with too much reserves?
- Reserves-- you don't get any interest on a reserve account
- or on cash.
- And that's actually how the-- if you were curious how the
- Fed actually supports itself-- well, it gives these banks
- reserve accounts, which are essentially checking accounts
- at the Fed-- and it gives them no interest on it.
- It gives them no interest so it has no interest on the
- right-hand side of their balance sheets.
- So it pays no interest on its liabilities.
- And its liabilities are these things right here.
- It pays no interest on these things, but it gets interest
- on some of its assets.
- So here I drew a little bit of gold.
- This yellow part is gold right here.
- Let me write that-- gold.
- This right here is gold and then this brown color-- we'll
- assume that these are treasuries, right?
- So if I have a government treasury, it gives me some
- interest. So I'm paying no interest if I'm the Fed.
- I'm paying no interest on these reserve deposits or on
- these notes outstanding.
- And I get interest on my assets.
- So that's easy money and it actually turns out that what
- the Fed does-- and this is why it's very ambiguous whether
- it's really independent of the government or not.
- It is officially a private institution, but it's a board
- of directors that's appointed by the government and even
- more, this money that it makes, any surplus money that
- it has after paying all of the expenses of the Federal
- Reserve, it actually goes back to Congress.
- So don't think that somehow there's this private bank with
- this great money making scheme because all the money goes
- back to Congress.
- Although that goes both ways.
- If for whatever reason, the Fed were to do really stupid
- things and it were to become insolvent, Congress is
- obligated-- we learned before that these treasury notes are
- obligations of the U.S. government.
- So it goes both ways.
- So even though it's officially independent, it really isn't.
- It really is almost a part of Congress-- or at least a part
- of the government.
- But with that said-- actually, I should say part of the
- Treasury, not so much part of Congress.
- I don't want to be technically incorrect.
- But with that said, let's go back to this example with
- these two banks.
- So this guy, he probably has more reserves than he needs.
- And he doesn't like having too much reserves because you
- don't get any interest on it.
- Let's say that this guy-- he wants 15% reserves.
- He figures that that's more than enough that he needs.
- And this guy, he feels like he's getting a little bit low
- on reserves.
- He would also like to get to 15%.
- So this guy would like to borrow this much money.
- Reserves would actually be physical cash or reserve
- deposits with the Fed.
- And this guy, he has about this much to lend.
- He has roughly about this much right here to lend-- and so
- the obvious thing, since there's only two banks in this
- universe, is that this guy would lend to that guy,
- probably overnight because you don't know what's going to
- happen tomorrow.
- Maybe some people are going to want their
- money back, et cetera.
- So we're just lending overnight.
- And if this guy still feels comfortable with the
- situation, he can continue that lending.
- This guy can renew his lending and this guy
- will renew it-- whatever.
- You get the idea.
- So the question is, what interest rate does this guy
- charge to that guy for lending this little chunk of money?
- Let's just say right now, this bank says, well, I'll charge
- you-- I don't know-- I'll charge you 10% overnight.
- So it's not like you're paying 10% just for a one night loan.
- It's an annual rate of 10%.
- So overnight, you're paying this to the 1/365 power or
- however many business days there are.
- So it's actually a very small amount of interest. These are
- kind of the annual rates if this guy were to continue
- borrowing it overnight and overnight for a whole year.
- With that said, let's say that the Fed decides the money
- supply isn't big enough.
- That the Fed wants to expand the money supply.
- So let's see what happens in that situation.
- So what was that mechanism?
- So what the Fed does is, it can print notes.
- Let's just say it's actual physical cash.
- That's an asset that the Fed is holding now.
- And of course it has an offsetting liability now,
- which is notes outstanding, right?
- And then what the Fed does is, it uses these notes and it can
- buy treasuries, it can buy risk free
- government debt, right?
- And it buys them in the open market.
- That debt might be being held by China.
- It might be being held by your grandmother.
- It could be being held by anyone.
- It might even be being held by some of these banks, but
- needless to say, they take this and they buy
- treasuries with it.
- So then that asset then turns to treasuries on the Fed's
- balance sheet.
- But where did all that cash go, right?
- Well, that cash will then go to your grandmother who was
- holding the treasuries.
- And what is your grandmother going to do with that cash?
- Well, your grandmother is going to put that cash in
- their bank, right?
- And maybe they're buying it from a lot of people's
- grandmothers.
- And so let's say some of the grandmothers put the
- money in this bank.
- I'm trying to draw it.
- So this bank gets a little bit more reserves.
- And then some of the grandmothers put it in this
- bank over here, right?
- And so what happened?
- What was the net effect of that?
- The government's balance sheet increased a little bit.
- If you look at its total assets, it's
- expanded a little bit.
- Or if you actually just look at its total liabilities.
- Its balance sheet grew.
- It took on some treasuries-- and we'll have a whole video
- on what the impact on treasury interest rates that does.
- But in the process, when it bought those treasuries on the
- open market, more cash got deposited
- into the banking system.
- And this could be cash or it could be reserves with the
- central bank.
- But now let's think about this situation
- between these two banks.
- Now all of a sudden this bank here needs less money, right,
- because he got some reserve deposits from our
- grandmothers.
- And also, this bank-- maybe now this guy went from 10%--
- maybe now he has a 12% reserve ratio because he got some
- deposits of actual cash.
- And maybe this guy went from 20% to-- I don't know-- 22%.
- So now this guy needs less money, right?
- His demand for money has been lowered, or for cash has been
- lowered, or his demand for reserves has been lowered.
- And this guy has even more to lend, right?
- He already had a surplus and now he has an even bigger
- surplus, right?
- So the supply of reserves has increased
- in the banking system.
- The supply his increased from the lending bank and the
- demand from the borrowing bank has lowered.
- So now for this transaction to occur, the demand has gone
- down, the supply has gone up.
- The price has got to go down for a
- little borrowing overnight.
- And what is the price of borrowing?
- Well, that's interest rates.
- So now for this transaction to occur, all of a sudden maybe
- this guy needs it less, this guy wants to lend even more
- because he has more.
- So now maybe this transaction will occur at
- an 8% interest rate.
- And maybe the Fed has a target rate of 5%.
- They want to see a reality where this bank is lending to
- that bank at a 5% rate.
- So what would they do?
- Well, they would just keep doing this process.
- They would issue a little bit more.
- I realize I'm not going to have time.
- But you see the process.
- They'd issue some more notes, buy some more treasuries.
- Those notes would end up in the banking system so the
- demand for overnight lending will go down and there'll be
- more of those reserves out there.
- So the rate at which people lend to each
- other will go down.
- Anyway, I'll see you in the next video.
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At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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