Learn about Banking 14: Fed Funds Rate Video

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Learn about Banking 14: Fed Funds Rate

So far we’ve talked about how the fed can control the money supply by performing this open market transaction with their buying and selling treasuries 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 treasury 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 what we’ll try to go over right now. So we’re going to focus on is the target rate and probably in the next video and the couple more videos, we’ll focus more on the discount rate. And they're 2 different things although they're often used in conjunction with each other and they're kind of they move in tandem. But let's focus on the target rate because this is have the fed under normal conditions normally sets its monetary paralleled 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 in a very short term basis, so overnight. What does that mean? So I drew 2 banks here and I doodled a little bit than I normally do this. Your 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 a little confusion when you compare the reserves to the demand deposits. I'm assuming all of the liabilities are demand deposits and they're not taking other types of laws. 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 reserves in green and this could be actual dollars, this could be actual cash that’s sitting in there in their vault. Or it could be demand, it could be reserved deposits with the federal reserve. They're really the same thing and they can go back and forth. So I think that’s kind of it, you understand that now. And just so you understand, this asset is a liability of the federal reserve, maybe it’s roughly that much of it. So that’s that. An asset for the bank liability for fed 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 to deposit account or reserve deposit account with the federal reserve and 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 and I think it looks nice when I color in the squares. This bank, its reserve just the way I’ve drawn it are clearly, its reserve is clearly lower than this bank because this is its demand deposit. This is its reserves. Let's say that this bank has reserves on this, I’m just eye balling it off and it looks 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%. Well this one looks more like it has closer to 20% reserves. And now remember, banks, you know 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 would always want to keep some reserves. But you don’t want to keep too much reserves. Because what happens if too much reserves? Reserves, you don’t get any interest on a reserve account or on cash. And that’s how actually how the, if you're 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 the balance sheet. So if there's no interest on its liabilities. And its liabilities are these things right here. If there's 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. This right here is gold. And then I just 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 this reserve deposits or on this notes outstanding. And I get interest on my assets, so that’s easy money. And it actually turns out that what the fed does, this is why it’s very ambiguous, whether it’s really independent of the government or not. It is officially a private institution, but its board of directors is 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. All though that goes both ways, for whatever reason, the Fed where to do really stupid things and it were to become insolvent. Congress is obligated, we learned before that these treasury notes are obligation of the US 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, well actually I should say part of the treasury, not so much the congress. I don’t want to be technically incorrect. But with that said, let's go back to this example, these two banks. So this guy, he probably has more reserve than he needs. Nas he doesn’t like having too much reserve because you don’t get any interest on it. Let’s say that this guy, he wants 15% reserves that 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. This much reserves. Right. Reserves would actually be physical cash or reserve deposits with the Fed. And this guy, he has about this much to lend. Right, he has roughly about this much right here to lend. And so the obvious things, since there is only two banks in this universe. So 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. Were 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. You get the idea. So the question is, what interest rate does this guy charged to that guy for lending this little chunk of money overnight to this? Let’s just say, right now this bank says, oh I’ll charge you 10% overnight. So it’s not your paying 10% just for one night loan. It’s an annual rate of 10%. So overnight for paying some this to the 1/365th power or how many business days. So it’s actually a very small amount of interest, these are kind of the annual rate of this guy were to continue borrowing overnight and overnight for a whole year. But with that said. Let's say that the Fed decides that the money supply isn’t big enough. The Fed wants to expand the money supply. So let's see what happens in that situation. So what was that mechanism? What the Fed does is it can print notes, let's just say its actual physical cash. So there you go, it prints some notes. 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, it uses these notes and it can buy treasuries. It can buy risk free government debt. Right. So what it does, and it buys them in an open market. Maybe 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 turns to treasuries on the Fed balance sheet. But where did all that cash go? Right. Well that cash will then go to your grandmother who is holding the treasuries. And what is your grandmother going to do with that cash? Well your grandmother’s going to put that cash in their bank. Right. And maybe their buying it from a lot of people’s grandmothers. And so, let's say someone’s grandmother put money in this bank, so this bank gets a little bit more reserves. And then some of the grandmothers put it in this bank over here. And so what happens? What was the net effect of that? The government’s balance sheet increase 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 I will have a whole video on what the impact on treasury interest rate that does. But in the process, when I bought those treasuries in the open market, more cash get deposited to the banking system. And this could be cash or it could be reserves with the central bank. But now let's think about the 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 from 10%. Maybe now he has a 12% reserve ratio. Because you got some deposit of actual cash. And maybe this guy went from 20% to, I don’t know 22%. So now this guy needs less money, he’s demand for money has been lowered or for cash has been lowered. The demand for reserves has been lowered. And this guy has even more to lend, right. He already had a surplus, now he has even a bigger surplus. Right. So the supply of reserves has increased in the banking system. The supply has 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 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, they have a target rate of 5%. They want to see a reality where this bank gets lending to that bank at a 5% rate. So what would they do, well they will just keep doing this process. They would maybe issue a little bit more, I just realize I don’t have enough 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 they’ll be more of those reserves out there. So that 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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So far we’ve talked about how the fed can control the money supply by performing this open market transaction with their buying and selling treasuries 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 treasury 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 what we’ll try to go over right now.
So we’re going to focus on is the target rate and probably in the next video and the couple more videos, we’ll focus more on the discount rate. And they're 2 different things although they're often used in conjunction with each other and they're kind of they move in tandem. But let's focus on the target rate because this is have the fed under normal conditions normally sets its monetary paralleled 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 in a very short term basis, so overnight. What does that mean? So I drew 2 banks here and I doodled a little bit than I normally do this. Your 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 a little confusion when you compare the reserves to the demand deposits. I'm assuming all of the liabilities are demand deposits and they're not taking other types of laws. 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 reserves in green and this could be actual dollars, this could be actual cash that’s sitting in there in their vault. Or it could be demand, it could be reserved deposits with the federal reserve. They're really the same thing and they can go back and forth. So I think that’s kind of it, you understand that now. And just so you understand, this asset is a liability of the federal reserve, maybe it’s roughly that much of it. So that’s that. An asset for the bank liability for fed 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 to deposit account or reserve deposit account with the federal reserve and 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 and I think it looks nice when I color in the squares. This bank, its reserve just the way I’ve drawn it are clearly, its reserve is clearly lower than this bank because this is its demand deposit. This is its reserves. Let's say that this bank has reserves on this, I’m just eye balling it off and it looks 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%. Well this one looks more like it has closer to 20% reserves. And now remember, banks, you know 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 would always want to keep some reserves. But you don’t want to keep too much reserves. Because what happens if too much reserves? Reserves, you don’t get any interest on a reserve account or on cash. And that’s how actually how the, if you're 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 the balance sheet.
So if there's no interest on its liabilities. And its liabilities are these things right here. If there's 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. This right here is gold. And then I just 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 this reserve deposits or on this notes outstanding. And I get interest on my assets, so that’s easy money. And it actually turns out that what the fed does, this is why it’s very ambiguous, whether it’s really independent of the government or not. It is officially a private institution, but its board of directors is 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. All though that goes both ways, for whatever reason, the Fed where to do really stupid things and it were to become insolvent. Congress is obligated, we learned before that these treasury notes are obligation of the US 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, well actually I should say part of the treasury, not so much the congress. I don’t want to be technically incorrect. But with that said, let's go back to this example, these two banks.
So this guy, he probably has more reserve than he needs. Nas he doesn’t like having too much reserve because you don’t get any interest on it. Let’s say that this guy, he wants 15% reserves that 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. This much reserves. Right. Reserves would actually be physical cash or reserve deposits with the Fed. And this guy, he has about this much to lend. Right, he has roughly about this much right here to lend. And so the obvious things, since there is only two banks in this universe. So 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. Were 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. You get the idea.
So the question is, what interest rate does this guy charged to that guy for lending this little chunk of money overnight to this? Let’s just say, right now this bank says, oh I’ll charge you 10% overnight. So it’s not your paying 10% just for one night loan. It’s an annual rate of 10%. So overnight for paying some this to the 1/365th power or how many business days. So it’s actually a very small amount of interest, these are kind of the annual rate of this guy were to continue borrowing overnight and overnight for a whole year.
But with that said. Let's say that the Fed decides that the money supply isn’t big enough. The Fed wants to expand the money supply. So let's see what happens in that situation. So what was that mechanism? What the Fed does is it can print notes, let's just say its actual physical cash. So there you go, it prints some notes. 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, it uses these notes and it can buy treasuries. It can buy risk free government debt. Right. So what it does, and it buys them in an open market. Maybe 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 turns to treasuries on the Fed balance sheet. But where did all that cash go? Right. Well that cash will then go to your grandmother who is holding the treasuries. And what is your grandmother going to do with that cash? Well your grandmother’s going to put that cash in their bank. Right. And maybe their buying it from a lot of people’s grandmothers.
And so, let's say someone’s grandmother put money in this bank, so this bank gets a little bit more reserves. And then some of the grandmothers put it in this bank over here. And so what happens? What was the net effect of that? The government’s balance sheet increase 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 I will have a whole video on what the impact on treasury interest rate that does. But in the process, when I bought those treasuries in the open market, more cash get deposited to the banking system. And this could be cash or it could be reserves with the central bank.
But now let's think about the 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 from 10%. Maybe now he has a 12% reserve ratio. Because you got some deposit of actual cash. And maybe this guy went from 20% to, I don’t know 22%. So now this guy needs less money, he’s demand for money has been lowered or for cash has been lowered. The demand for reserves has been lowered. And this guy has even more to lend, right. He already had a surplus, now he has even a bigger surplus. Right. So the supply of reserves has increased in the banking system. The supply has 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 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, they have a target rate of 5%. They want to see a reality where this bank gets lending to that bank at a 5% rate. So what would they do, well they will just keep doing this process. They would maybe issue a little bit more, I just realize I don’t have enough 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 they’ll be more of those reserves out there. So that the rate at which people lend to each other will go down.
Anyway, I’ll see you in the next video.

Transcription by: Scribe4you Transcription Services