Learn about Banking 13: Open Market Operations Video

By: Guest 11 months ago

Hi, 1st of all thx for the vid, but I have to stress that the CRR explanation is wrong and could mislead the viewers. If the central bank dictates that the CRR is 0.5 (50%) that means that banks should always keep at least 50% of the money their clients deposit on hand. Example: If a person deposits $100, the bank is obliged, by the Feds' CRR, to have at least $50 on hand at their demand deposits.

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Learn about Banking 13: Open Market Operations

In the last video, I hinted that this was leading to a discussion of an elastic money supply or supply of money that can change depending on the needs for the money. So before we go there I took a little high here. I just told you a little bit about treasuries because that’s a critical component. Let’s review what the money supply even is, so there were two definitions. When we had originally talked about kind of an M zero I talked about just the gold reserves. But now we’re going to expand that definition a little bit and I think you can tell, well I’ve got a lot of questions about this about eventually getting off a gold reserve system and we really get there and we’re kind of already there but now I’ll consider the based money supply as Federal Reserve deposits and notes. So in this reality that I just created, all of the Federal Reserve deposits have essentially could turn into notes. But if this bank didn’t want all cash, it could have had some of this with just to checking account with the Federal Reserve Bank. So a Federal Reserve note in a Federal Reserve deposit account is essentially the same thing. A note is just a little bit more fungible, you can hand it to someone and then they can hand it to someone else while checking account or demand account with the Federal Reserve Bank you have to kind of do a wire transfer or write a check etcetera. But that is the based money supply. You could call that based money and that essentially the size of the liabilities of the Federal Reserve in very broad terms. We’ll go into detail on the actual Federal Reserves balance sheet in the near future. So in this example right now our base money supply is 200, let’s call it dollars now. Let’s move away from gold pieces, let’s just say a dollar equals a gold piece for the sake of our instruction right now. So our base money supply and I’ll call that M zero. M zero right now is 200 and that’s the cash out there which are the Federal Reserve notes plus the Federal Reserve demand deposits. So for example, this could have been just like a checking account at the Reserve Bank and then this over here would have been a checking account instead. But it would still be considered part of the base money supply because if this bank while checking accounts it’s all I just want that in terms of notes then the Federal Reserve Bank will just issue notes and cancel out this checking account and it would return back into notes. So they’re equivalent, they’re just a different way of keeping track of it, so that’s the base money supply. Now a slightly broader definition of the money supply and we could call this bank money sometimes referred a formal definition is M one and that’s essentially that notion should that I won over I think almost ten videos ago. How much money do people think they have and that’s the amount of money in demand deposit accounts? So that in this case, that’s this so all the people in this bank they think they have a hundred dollars there, right. That’s a hundred dollars that they think that they have that they can write checks against and in this bank also has another hundred dollars. And so they’re the base money supply, that’s not right. I don’t know sorry they don’t have a hundred why I am saying a hundred. This bank had a hundred in gold and it could lend out up to 200 or could put out up to 200 in checking deposit account. So it has 200. That’s what I was, right we talk about earlier in the last video that we have a 50% reserve ratio which tells us that if this bank has a hundred dollars in reserves then it can essentially manage or it can issue $200.00 in demand deposit accounts. And we went over that many times and how that happens and in this bank can do the same. It will have 200 in demand deposit accounts. And so the total amount of money that people think they have either in demand deposit accounts and this situation I’m assuming all of the cash sitting in the Reserve Banks although we do know that some of this is going to be sitting around circulating. But let’s just say we living in a world where everyone uses debit cards all the time and no one uses cash and I think we’re heading to that world very quickly and as we’ll see soon that actually increases the money supply when you do that. But anyway, I don’t want to go to technical just yet but the M one which is the total amount of demand deposit accounts in our universe is 400 and this relationship makes a lot sense because our reserve requirements are 50%. So we can kind of assume that banks tend to get as close to their reserve requirement as they can because they don’t get interests on reserves, they make interest on the loans that they make against checking demand accounts. So if the reserve requirements were 10% and our base money was 200 we would probably see 2000 in the M one supply. So my question to you is and maybe you want to pause and think about this is how can the government or the central bank or how can the economy increase or decrease the money supply? I guess the first question is a why would you want it increase or decrease the money supply? Well let’s say we’re in this world already and we only have these two banks and we have an M one supply of 400. But let’s save the economy expense, we have more goods and services that we are able to produce. Maybe we have immigrants come in so we have more labor, maybe we have some innovative technology, maybe the whole or maybe just seasonal, maybe it’s the crop-planting season. So a lot of farmers need their cash in order to hire people to plant the crops. So that’s another time where you’d want more money. If you don’t increase the money supply at those times when you have economic expansion or there is more demand because of some type of seasonal fluctuation. If you don’t increase the money then what are you going to do is money is going to become more expensive and I’ll do a whole video on that so don’t get too confused. But money getting more expensive means that interest rates will go up and if money becomes too expensive then some good projects, maybe some farmers who might have planted seeds wouldn’t be able to and so you would kind of restrict economic expansion. But we’ll have a whole lot of discussion on when does it make sense to expand your contract money. Let’s just talk now about how you would actually do it. So there are two ways. I just said if this reserve requirement were ten percent then these banks could create more checking accounts, right? They could lend out more money and create more checking accounts if the reserve requirement were ten percent. If it was ten percent then you would have M one of 2000. It will be ten times instead of two times this. And that is considered one of the tools of the Federal Reserve Bank because we said in the past that the Federal Reserve Bank actually sets these reserve requirements. But the problem with that tool if you think about it is what happens if we made our reserve requirement ten percent and all of sudden all of this bank started lending a lot more money then they only had ten percent, the ratio of reserve to checking account for a ten percent. Think about what would happen if we want to raise the reserve requirement back to 50% then all of the banks they’d only have ten percent reserves, how will they get back to 50%? All of these banks would have to either start selling assets or unwinding loans would be a very messy situation if you were to lower the reserve requirement than you wanted to actually increase it again. You would actually make a lot of banks become under capitalize because most banks just operate right where they need to. So you really don’t want to mess around with this reserve requirement much. So the question is, if you’re not going to change the reserve requirement which is the ratio of the reserves to checking accounts. If you’re not going to mess with that, the only other way that you can actually increase the number of checking account is if somehow you can increase the reserves. If you could somehow add some actual reserves over here, so my question is how can you do that? Well let’s just say that well we’re hopefully already reasonably familiar with fractional reserve banking. So you might have seen it coming that also applies to the Central Bank. So the central bank right now all its deposits were directly back by gold one to one. But there’s nothing to stop this bank from also doing fractional reserve lending and actually the Central Bank has no reserve requirements and that’s because to some degree it can always provide the liquidity because its notes or obligations of the government. So you can always tax more people to back up its loans. So what essentially the Federal Reserve can do is and this is the printing press of the base money supply that people talk about but there are two printing presses. There’s a base money printing press and then there’s the leverage printing press. So if this increases well I’ll do a whole video on that and I don’t want to get too technical because I realized I’m running out of time. So what the Federal Reserve could do in this situation is it can print some notes. So let’s say it prints a hundred of notes, right? And it literally just prints those dollars that pays the treasury to the printed form but it creates these notes and then of course of setting that is a liability, right. Notes outstanding a hundred liability and then what it does is, it takes this hundred dollars. I mean these are literally dollar bills although it could be some type of demand account, whatever. But it takes is hundred dollar bills that it printed and it’s just the off setting liability and then it can buy treasuries securities. So what happens? If it takes this hundred dollar bills and base treasuries and the treasuries don’t have to be issued by the government anymore because whenever the government does issue treasuries, its bought by just a bunch of people in the world that there’s always a bunch of treasuries sitting out there as long as the treasury has some debt. So I was holding the treasuries and then let’s say that this is the Central Bank. I was holding some of this government IOU’s right that I had bought from the government and the Federal Reserve. They have a hundred dollars so they just buy the treasury from me and you know maybe I don’t want to sell the current so they have to pay me a little more than the current price in order for me to part with it and I’ll do a whole other video on what that means and how that changes the yield curve and all of that. But I just want to give you that based notion that the treasury essentially creates a note outstanding liability and has an off setting hundred dollars of dollar bills and that it just created or print and then it can use those hundred dollar bills to buy treasuries or government IOU’s in the open market. Now what happens here? Well this hundred dollar bills this are now treasuries and my question to you is I was holding a treasury I was sitting on my mattress. Now I don’t have a treasury I have a hundred dollars, what I am going to do with that hundred dollars? Well I’m going to deposit it in the bank so this is me depositing my hundred dollars. I mean maybe deposited up here but and I have my checking account grow a little bit. But what’s the net effect? Now all of a sudden the banking system, the National Banking System has more currency, more dollar reserves that apply through its reserve ratio so now it got my hundred-dollar deposit. Now it can also do another hundred dollars of lending. So I would have essentially increased the based so now the M zero goes from 200 to 300 because I have 300 notes outstanding and now my M one, I took that hundred-dollar bill that the treasury gave me. Deposit it in the bank account, now I have a bank account that says a hundred and because of a 50% reserve requirement, the bank can issue another loan. I know it’s getting messy 400. So essentially we are M one is now 600 so just like that, just by printing money and issuing treasuries, the Central Bank was able to increase the M one by $200.00. I’ll do more videos on this, I don’t want to confuse you too much, see you soon.

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In the last video, I hinted that this was leading to a discussion of an elastic money supply or supply of money that can change depending on the needs for the money. So before we go there I took a little high here. I just told you a little bit about treasuries because that’s a critical component. Let’s review what the money supply even is, so there were two definitions. When we had originally talked about kind of an M zero I talked about just the gold reserves.

But now we’re going to expand that definition a little bit and I think you can tell, well I’ve got a lot of questions about this about eventually getting off a gold reserve system and we really get there and we’re kind of already there but now I’ll consider the based money supply as Federal Reserve deposits and notes. So in this reality that I just created, all of the Federal Reserve deposits have essentially could turn into notes. But if this bank didn’t want all cash, it could have had some of this with just to checking account with the Federal Reserve Bank.

So a Federal Reserve note in a Federal Reserve deposit account is essentially the same thing. A note is just a little bit more fungible, you can hand it to someone and then they can hand it to someone else while checking account or demand account with the Federal Reserve Bank you have to kind of do a wire transfer or write a check etcetera. But that is the based money supply. You could call that based money and that essentially the size of the liabilities of the Federal Reserve in very broad terms. We’ll go into detail on the actual Federal Reserves balance sheet in the near future.

So in this example right now our base money supply is 200, let’s call it dollars now. Let’s move away from gold pieces, let’s just say a dollar equals a gold piece for the sake of our instruction right now. So our base money supply and I’ll call that M zero. M zero right now is 200 and that’s the cash out there which are the Federal Reserve notes plus the Federal Reserve demand deposits.

So for example, this could have been just like a checking account at the Reserve Bank and then this over here would have been a checking account instead. But it would still be considered part of the base money supply because if this bank while checking accounts it’s all I just want that in terms of notes then the Federal Reserve Bank will just issue notes and cancel out this checking account and it would return back into notes. So they’re equivalent, they’re just a different way of keeping track of it, so that’s the base money supply.

Now a slightly broader definition of the money supply and we could call this bank money sometimes referred a formal definition is M one and that’s essentially that notion should that I won over I think almost ten videos ago. How much money do people think they have and that’s the amount of money in demand deposit accounts? So that in this case, that’s this so all the people in this bank they think they have a hundred dollars there, right. That’s a hundred dollars that they think that they have that they can write checks against and in this bank also has another hundred dollars. And so they’re the base money supply, that’s not right. I don’t know sorry they don’t have a hundred why I am saying a hundred.

This bank had a hundred in gold and it could lend out up to 200 or could put out up to 200 in checking deposit account. So it has 200. That’s what I was, right we talk about earlier in the last video that we have a 50% reserve ratio which tells us that if this bank has a hundred dollars in reserves then it can essentially manage or it can issue $200.00 in demand deposit accounts. And we went over that many times and how that happens and in this bank can do the same. It will have 200 in demand deposit accounts. And so the total amount of money that people think they have either in demand deposit accounts and this situation I’m assuming all of the cash sitting in the Reserve Banks although we do know that some of this is going to be sitting around circulating.

But let’s just say we living in a world where everyone uses debit cards all the time and no one uses cash and I think we’re heading to that world very quickly and as we’ll see soon that actually increases the money supply when you do that. But anyway, I don’t want to go to technical just yet but the M one which is the total amount of demand deposit accounts in our universe is 400 and this relationship makes a lot sense because our reserve requirements are 50%.

So we can kind of assume that banks tend to get as close to their reserve requirement as they can because they don’t get interests on reserves, they make interest on the loans that they make against checking demand accounts. So if the reserve requirements were 10% and our base money was 200 we would probably see 2000 in the M one supply. So my question to you is and maybe you want to pause and think about this is how can the government or the central bank or how can the economy increase or decrease the money supply?

I guess the first question is a why would you want it increase or decrease the money supply? Well let’s say we’re in this world already and we only have these two banks and we have an M one supply of 400. But let’s save the economy expense, we have more goods and services that we are able to produce. Maybe we have immigrants come in so we have more labor, maybe we have some innovative technology, maybe the whole or maybe just seasonal, maybe it’s the crop-planting season. So a lot of farmers need their cash in order to hire people to plant the crops. So that’s another time where you’d want more money.

If you don’t increase the money supply at those times when you have economic expansion or there is more demand because of some type of seasonal fluctuation. If you don’t increase the money then what are you going to do is money is going to become more expensive and I’ll do a whole video on that so don’t get too confused. But money getting more expensive means that interest rates will go up and if money becomes too expensive then some good projects, maybe some farmers who might have planted seeds wouldn’t be able to and so you would kind of restrict economic expansion. But we’ll have a whole lot of discussion on when does it make sense to expand your contract money. Let’s just talk now about how you would actually do it.

So there are two ways. I just said if this reserve requirement were ten percent then these banks could create more checking accounts, right? They could lend out more money and create more checking accounts if the reserve requirement were ten percent. If it was ten percent then you would have M one of 2000. It will be ten times instead of two times this. And that is considered one of the tools of the Federal Reserve Bank because we said in the past that the Federal Reserve Bank actually sets these reserve requirements.

But the problem with that tool if you think about it is what happens if we made our reserve requirement ten percent and all of sudden all of this bank started lending a lot more money then they only had ten percent, the ratio of reserve to checking account for a ten percent. Think about what would happen if we want to raise the reserve requirement back to 50% then all of the banks they’d only have ten percent reserves, how will they get back to 50%?

All of these banks would have to either start selling assets or unwinding loans would be a very messy situation if you were to lower the reserve requirement than you wanted to actually increase it again. You would actually make a lot of banks become under capitalize because most banks just operate right where they need to. So you really don’t want to mess around with this reserve requirement much. So the question is, if you’re not going to change the reserve requirement which is the ratio of the reserves to checking accounts. If you’re not going to mess with that, the only other way that you can actually increase the number of checking account is if somehow you can increase the reserves. If you could somehow add some actual reserves over here, so my question is how can you do that?

Well let’s just say that well we’re hopefully already reasonably familiar with fractional reserve banking. So you might have seen it coming that also applies to the Central Bank. So the central bank right now all its deposits were directly back by gold one to one. But there’s nothing to stop this bank from also doing fractional reserve lending and actually the Central Bank has no reserve requirements and that’s because to some degree it can always provide the liquidity because its notes or obligations of the government. So you can always tax more people to back up its loans.

So what essentially the Federal Reserve can do is and this is the printing press of the base money supply that people talk about but there are two printing presses. There’s a base money printing press and then there’s the leverage printing press. So if this increases well I’ll do a whole video on that and I don’t want to get too technical because I realized I’m running out of time. So what the Federal Reserve could do in this situation is it can print some notes. So let’s say it prints a hundred of notes, right? And it literally just prints those dollars that pays the treasury to the printed form but it creates these notes and then of course of setting that is a liability, right. Notes outstanding a hundred liability and then what it does is, it takes this hundred dollars. I mean these are literally dollar bills although it could be some type of demand account, whatever. But it takes is hundred dollar bills that it printed and it’s just the off setting liability and then it can buy treasuries securities.

So what happens? If it takes this hundred dollar bills and base treasuries and the treasuries don’t have to be issued by the government anymore because whenever the government does issue treasuries, its bought by just a bunch of people in the world that there’s always a bunch of treasuries sitting out there as long as the treasury has some debt.

So I was holding the treasuries and then let’s say that this is the Central Bank. I was holding some of this government IOU’s right that I had bought from the government and the Federal Reserve. They have a hundred dollars so they just buy the treasury from me and you know maybe I don’t want to sell the current so they have to pay me a little more than the current price in order for me to part with it and I’ll do a whole other video on what that means and how that changes the yield curve and all of that.

But I just want to give you that based notion that the treasury essentially creates a note outstanding liability and has an off setting hundred dollars of dollar bills and that it just created or print and then it can use those hundred dollar bills to buy treasuries or government IOU’s in the open market. Now what happens here? Well this hundred dollar bills this are now treasuries and my question to you is I was holding a treasury I was sitting on my mattress. Now I don’t have a treasury I have a hundred dollars, what I am going to do with that hundred dollars?

Well I’m going to deposit it in the bank so this is me depositing my hundred dollars. I mean maybe deposited up here but and I have my checking account grow a little bit. But what’s the net effect? Now all of a sudden the banking system, the National Banking System has more currency, more dollar reserves that apply through its reserve ratio so now it got my hundred-dollar deposit.

Now it can also do another hundred dollars of lending. So I would have essentially increased the based so now the M zero goes from 200 to 300 because I have 300 notes outstanding and now my M one, I took that hundred-dollar bill that the treasury gave me. Deposit it in the bank account, now I have a bank account that says a hundred and because of a 50% reserve requirement, the bank can issue another loan. I know it’s getting messy 400. So essentially we are M one is now 600 so just like that, just by printing money and issuing treasuries, the Central Bank was able to increase the M one by $200.00. I’ll do more videos on this, I don’t want to confuse you too much, see you soon.

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