Learn about Banking 15: More on the Fed Funds Rate Video

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Learn about Banking 15: More on the Fed Funds Rate

Let's review a little bit of what we we’ve gone over. And I think it helps to see the whole process again just so it really sinks in to your brain. And I've drawn the banks in a different arrangement this time. But this is a review. This is a bank with a little bit less reserves, the green right here is their reserves. It could either be deposits at the Federal Reserve or this could actually be Federal Reserve notes and we all know that as dollars or cash. This is another bank with slightly more reserves just like I said in the last video. I'm drawing the reserves at the top of the asset side now so that we can compare directly with the demand deposits where the liabilities at this bank. Most banks have other liabilities but I’ve just assumed that all of them are demand deposits. And that’s this magenta square here. And of course their equity is the blue right there. That’s their equity. And of course either if these are Federal Reserve notes or these are deposits within the reserve bank, those of course are liabilities for the reserve bank itself. Let me draw a line there. This is a liability for the reserve bank. If these were deposits, these were essentially demand accounts with the reserve bank, then you know, we can even divide them up a little bit. Okay, so this guy has this much, I don’t know if you can see that. The color is not so good. This guy has this much, this guy has this much. But if these are all Federal Reserve notes and they kind of all come out of the same bucket. And what we learned in the last video is that the Federal Reserve, they don’t say, we want the money supply to be X or Y. they always talked about in terms of interest rates. They always say, our target interest rate or the Federal Reserve rate is now going to be X. So let's go over our mechanics a little bit more on how open market transactions help to make those rates happen. So let's say that on day one or before the Fed does anything, this bank has a little bit of extra reserves, this bank has a little bit less reserves. So there's a couple of things this bank could do with this extra reserves. It could either maybe make do some more lending, so it could actually get reserves. I don’t want to get too specific with the numbers, let's say that’s at a 20% to reserve ratio. This ratio to this, 20%. And it can be as low as, you know, it would feel comfortable being at 15% reserve ratio. So roughly, a fourth of its reserves could be used for doing something else. So what could it be use for? So let's say this portion of its reserve could be use for something else. Well, it could lend them to another bank who maybe needs reserves. So that could be this right here. This bank maybe want some reserves and they will add it up on here. Although in the last video, I filled in the reserves down here. But actually, they're not replacing other assets, they would have been actually just been added to the balance sheet of the bank. So I should draw them on top. And I’ll do that in a second. But the other option that this bank could do is they could actually do more lending. Since the reserve ratio is higher than they want, they can actually create checking accounts like we saw in the last couple of videos. But with that said, let's say that they want, this guy wants to borrow some. This guy’s willing to lend some. Although that’s not his only alternative, he could create checking accounts essentially and do some more lending with it. And let's say in this reality right now, given how much reserves are on the banking system at the current rate. Let me write that over here, current rate. The current rate is 6%. Now the Federal Reserve says, you know, I would like to expand the money supply. And they don’t say it directly. They don’t tell us, you know, in our newspapers. They don’t make press release. We would like the official M1 value of the money supply to go from $15 trillion to $20 trillion, they don’t say that. They say, we are going to lower the Fed Fund Rate to 5%. Fed Fund Rate, they're setting to be 5%. The governors of the Federal Reserve bank sit together and Burnecky comes out and says, we are lowering the Fed Fund Rate to 5%. So what that 5% means is that their target rate is now 5%. So this is a target. So what they're saying is, is we are going to perform open market transactions in such a way that now when this bank offers money to this bank, it’s going to reduce its rate from 6% to 5%. Or another way to put it, they're going to do open market transactions or operations in such a way that the demand might also go down for the reserves so this guy might be willing to pay less for borrowing from this guy. Instead of willing to pay 6%, he’ll be willing to pay 5%. Remember, on any transaction. Both people have to agree on them. So how do they do that, and I think were reasonably familiar with the mechanics now. So the Federal Reserve could do is that they can print some notes, those are assets. Because they haven’t done anything with them yet. And then there's a corresponding liability, I’ll do that in a slightly different shade of green. There's a corresponding liability. These are notes outstanding. Alright. These are the liabilities, the light green are the assets, the notes themselves. And what the Federal Reserve does, because they don’t want to become an insolvent bank. So they want to buy the most liquid safest assets out there. And it actually makes a lot of sense. And we’ll touch on this in a lot of different ways. Well they say, were going to take this money and inject it into the system by buying treasuries with it. And they could be buying those treasuries from your grandmother. They could be buying it from China. They could be buying them from Russia. They could be buying it from me. They could be borrowing it from my uncle. Regardless of who they buy it from, let's say that they buy from someone in the US so that we don’t get confuse right now. Let’s say they buy it from my uncle. So this is my uncle, let me see if I can draw him. This is my uncle. He’s holding a treasury right now. An IOU from the government. That’s what he has. He wasn’t willing to sell it before, but let's say the Federal Reserve has printed more money and he’s like, I'm not going to sell it now. But if someone is willing to offer me a little bit more money for it, maybe I'm willing to part with my treasury bill. So the Federal Reserve, and he doesn’t know that he’s selling to Federal Reserve. He just sees like selling it to the market. The same way that when you buy a stock, you don’t know who you're buying it from or who you're selling it to and all of that. So all of sudden, someone goes out there and is willing to pay slightly higher price for these treasury bills. These IOUs from the government. And he’s like, oh, fine that’s a good price. I'm going to sell them to whoever is buying it. It turns out that it’s actually the Federal Reserve that’s buying it. So the Federal Reserve all of a sudden, my uncle would be a big time operator if the Federal Reserve only bought from him. You would have to have hundreds of billions of dollars of these things. And he doesn’t have his IOUs anymore. What does he have right now? That IOU is now exchange for a dollar bill or hundreds of billions of dollar bills. Or reserve deposits of the Federal Reserve. All of the same, but we’ll, just to keep the abstractions solid for right now. We’ll keep it in terms of dollar bills. So he’s IOUs, he sold in exchange for these dollar bills. And what does he do with them? These are hundreds of billions of dollars. He’s not going to stuff it all in to his mattress. He’s going to deposit it into the banking system. Maybe he gives a little bit to this bank up here. And this like a slight mistake that I did in the last video, I was adding it below. But it’s not replacing other assets, it’s a new assets. So let's say he puts some of it here, my uncle, after he sold his treasuries. And let's say he puts some of it in this bank. Let me do that in a slightly different shade of green. Oh, I’ll do it in blue. To see that this is a new deposit. It’s close enough to green that I think you get the idea. And of course, he has an offsetting he’s checking account he doesn’t have one already. Now he has one, so their liability is increasing a little bit. So a couple things will happen, how does this affect the rate that they're charging to each other? Well now, all of sudden this bank’s reserve ratio has gotten a little bit better. His assets and liabilities increase, right. He’s assets increase by the amount of my uncle’s deposit. But so did the liabilities, because he has the demand deposit. But it came in a ratio of reserves to demand deposits, 100%. So this would’ve improved his reserve ratio if you were now to take the ratio of this height to this height. It’s not going to improve a little bit. Right. So now, this bank doesn’t need money bad in order to improve its reserve ratio. And likewise, this bank now even has even better reserve ratio. He already had more reserves than he needed. And now he got even more. He has even better reserve ratio. So now, this guy’s demand for a reserve is a little bit lower and this guy’s supply of reserves is a little bit higher. So this guy is only going to be willing to pay a little bit less for new reserves from this bank. And this guy, he’s willing to charge less now because he has more. He doesn’t know what to do with it. He doesn’t know enough people who want to borrow more money. So he wants to actually lend off some of he’s reserves. So just by increasing the supply of reserves, and decreasing the demand of reserves. The current rate, if the Fed does this appropriately, will go to 5%. And let's say they want it to only go to 5 and a half percent, then the Fed will keep doing this. And then it will go to five and a half percent. If it goes too far, if it goes to four and a half percent, maybe the Fed will reverse the transaction. The Fed will actually go out there and sell these treasury notes. But I also make it clear that the point of this, although it does affect the interest rate, and that’s what the Federal Reserve always talks about in terms of their target rate. The net effect of injecting more reserves into the system is it increases the lending power of the bank. And if we have, let's say 10% reserve ratio, every dollar that is injected into the banking system. Right there. That bank can do $10 worth of lending. And let's say that that bank lends it all to this bank. Let's say he lends all of that, so now it turns into an asset which is a loan to this bank. So this bank then has, this isn’t a demand deposit anymore, this is now a loan from this bank. He has more reserves now, that’s his reserve. But the bottom line is wherever those reserves are, it doesn’t matter which banks they sit in. but they enable every dollar of that increase reserves enables $10 of lending. Right. This bank now can create $10 of checking accounts through lending. And so even though the Federal Reserve talks in terms of interest rates, and I’ll talk a lot more about why they are more focus on interest rates than absolute measures of the money supply. Even though they're talking in terms of interest rates, by performing this open market transactions that in effect lowers the interest rates by increasing the amount of reserves out there. They’re actually increasing bank’s lending capacity. So the amount of reserves, that’s base money or you can almost view it as the liability side of the Federal Funds. The reserve deposits, that’s base money, that’s M0. And you got a multiplier effect for M1, which is the amount of demand deposit. Because in this bank it got more reserve and then it can create a bunch of demand deposits like we learned earlier. So by saying that they're lowering the rates, they're essentially saying that they're going to perform open market transactions that will inject reserves in to the banking system which will allow them to keep their reserve ratios in line. But make a lot more loans. So significantly increase the M1 and the other broader definitions of money supply. I will see you in the next video.

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Let's review a little bit of what we we’ve gone over. And I think it helps to see the whole process again just so it really sinks in to your brain. And I've drawn the banks in a different arrangement this time. But this is a review. This is a bank with a little bit less reserves, the green right here is their reserves. It could either be deposits at the Federal Reserve or this could actually be Federal Reserve notes and we all know that as dollars or cash. This is another bank with slightly more reserves just like I said in the last video. I'm drawing the reserves at the top of the asset side now so that we can compare directly with the demand deposits where the liabilities at this bank. Most banks have other liabilities but I’ve just assumed that all of them are demand deposits. And that’s this magenta square here. And of course their equity is the blue right there. That’s their equity. And of course either if these are Federal Reserve notes or these are deposits within the reserve bank, those of course are liabilities for the reserve bank itself. Let me draw a line there. This is a liability for the reserve bank. If these were deposits, these were essentially demand accounts with the reserve bank, then you know, we can even divide them up a little bit. Okay, so this guy has this much, I don’t know if you can see that. The color is not so good.
This guy has this much, this guy has this much. But if these are all Federal Reserve notes and they kind of all come out of the same bucket. And what we learned in the last video is that the Federal Reserve, they don’t say, we want the money supply to be X or Y. they always talked about in terms of interest rates. They always say, our target interest rate or the Federal Reserve rate is now going to be X.
So let's go over our mechanics a little bit more on how open market transactions help to make those rates happen. So let's say that on day one or before the Fed does anything, this bank has a little bit of extra reserves, this bank has a little bit less reserves. So there's a couple of things this bank could do with this extra reserves. It could either maybe make do some more lending, so it could actually get reserves. I don’t want to get too specific with the numbers, let's say that’s at a 20% to reserve ratio. This ratio to this, 20%. And it can be as low as, you know, it would feel comfortable being at 15% reserve ratio. So roughly, a fourth of its reserves could be used for doing something else. So what could it be use for?
So let's say this portion of its reserve could be use for something else. Well, it could lend them to another bank who maybe needs reserves. So that could be this right here. This bank maybe want some reserves and they will add it up on here. Although in the last video, I filled in the reserves down here. But actually, they're not replacing other assets, they would have been actually just been added to the balance sheet of the bank. So I should draw them on top. And I’ll do that in a second. But the other option that this bank could do is they could actually do more lending. Since the reserve ratio is higher than they want, they can actually create checking accounts like we saw in the last couple of videos.
But with that said, let's say that they want, this guy wants to borrow some. This guy’s willing to lend some. Although that’s not his only alternative, he could create checking accounts essentially and do some more lending with it. And let's say in this reality right now, given how much reserves are on the banking system at the current rate. Let me write that over here, current rate. The current rate is 6%. Now the Federal Reserve says, you know, I would like to expand the money supply. And they don’t say it directly. They don’t tell us, you know, in our newspapers. They don’t make press release. We would like the official M1 value of the money supply to go from $15 trillion to $20 trillion, they don’t say that. They say, we are going to lower the Fed Fund Rate to 5%.
Fed Fund Rate, they're setting to be 5%. The governors of the Federal Reserve bank sit together and Burnecky comes out and says, we are lowering the Fed Fund Rate to 5%. So what that 5% means is that their target rate is now 5%. So this is a target. So what they're saying is, is we are going to perform open market transactions in such a way that now when this bank offers money to this bank, it’s going to reduce its rate from 6% to 5%. Or another way to put it, they're going to do open market transactions or operations in such a way that the demand might also go down for the reserves so this guy might be willing to pay less for borrowing from this guy. Instead of willing to pay 6%, he’ll be willing to pay 5%.
Remember, on any transaction. Both people have to agree on them. So how do they do that, and I think were reasonably familiar with the mechanics now. So the Federal Reserve could do is that they can print some notes, those are assets. Because they haven’t done anything with them yet. And then there's a corresponding liability, I’ll do that in a slightly different shade of green. There's a corresponding liability. These are notes outstanding. Alright. These are the liabilities, the light green are the assets, the notes themselves. And what the Federal Reserve does, because they don’t want to become an insolvent bank. So they want to buy the most liquid safest assets out there. And it actually makes a lot of sense. And we’ll touch on this in a lot of different ways.
Well they say, were going to take this money and inject it into the system by buying treasuries with it. And they could be buying those treasuries from your grandmother. They could be buying it from China. They could be buying them from Russia. They could be buying it from me. They could be borrowing it from my uncle. Regardless of who they buy it from, let's say that they buy from someone in the US so that we don’t get confuse right now. Let’s say they buy it from my uncle. So this is my uncle, let me see if I can draw him. This is my uncle. He’s holding a treasury right now. An IOU from the government. That’s what he has. He wasn’t willing to sell it before, but let's say the Federal Reserve has printed more money and he’s like, I'm not going to sell it now. But if someone is willing to offer me a little bit more money for it, maybe I'm willing to part with my treasury bill.
So the Federal Reserve, and he doesn’t know that he’s selling to Federal Reserve. He just sees like selling it to the market. The same way that when you buy a stock, you don’t know who you're buying it from or who you're selling it to and all of that. So all of sudden, someone goes out there and is willing to pay slightly higher price for these treasury bills. These IOUs from the government. And he’s like, oh, fine that’s a good price. I'm going to sell them to whoever is buying it. It turns out that it’s actually the Federal Reserve that’s buying it.
So the Federal Reserve all of a sudden, my uncle would be a big time operator if the Federal Reserve only bought from him. You would have to have hundreds of billions of dollars of these things. And he doesn’t have his IOUs anymore. What does he have right now? That IOU is now exchange for a dollar bill or hundreds of billions of dollar bills. Or reserve deposits of the Federal Reserve. All of the same, but we’ll, just to keep the abstractions solid for right now. We’ll keep it in terms of dollar bills.
So he’s IOUs, he sold in exchange for these dollar bills. And what does he do with them? These are hundreds of billions of dollars. He’s not going to stuff it all in to his mattress. He’s going to deposit it into the banking system. Maybe he gives a little bit to this bank up here. And this like a slight mistake that I did in the last video, I was adding it below. But it’s not replacing other assets, it’s a new assets. So let's say he puts some of it here, my uncle, after he sold his treasuries. And let's say he puts some of it in this bank.
Let me do that in a slightly different shade of green. Oh, I’ll do it in blue. To see that this is a new deposit. It’s close enough to green that I think you get the idea.
And of course, he has an offsetting he’s checking account he doesn’t have one already. Now he has one, so their liability is increasing a little bit. So a couple things will happen, how does this affect the rate that they're charging to each other? Well now, all of sudden this bank’s reserve ratio has gotten a little bit better. His assets and liabilities increase, right. He’s assets increase by the amount of my uncle’s deposit. But so did the liabilities, because he has the demand deposit. But it came in a ratio of reserves to demand deposits, 100%. So this would’ve improved his reserve ratio if you were now to take the ratio of this height to this height. It’s not going to improve a little bit. Right.
So now, this bank doesn’t need money bad in order to improve its reserve ratio. And likewise, this bank now even has even better reserve ratio. He already had more reserves than he needed. And now he got even more. He has even better reserve ratio. So now, this guy’s demand for a reserve is a little bit lower and this guy’s supply of reserves is a little bit higher. So this guy is only going to be willing to pay a little bit less for new reserves from this bank. And this guy, he’s willing to charge less now because he has more. He doesn’t know what to do with it. He doesn’t know enough people who want to borrow more money. So he wants to actually lend off some of he’s reserves.
So just by increasing the supply of reserves, and decreasing the demand of reserves. The current rate, if the Fed does this appropriately, will go to 5%. And let's say they want it to only go to 5 and a half percent, then the Fed will keep doing this. And then it will go to five and a half percent. If it goes too far, if it goes to four and a half percent, maybe the Fed will reverse the transaction. The Fed will actually go out there and sell these treasury notes.
But I also make it clear that the point of this, although it does affect the interest rate, and that’s what the Federal Reserve always talks about in terms of their target rate. The net effect of injecting more reserves into the system is it increases the lending power of the bank. And if we have, let's say 10% reserve ratio, every dollar that is injected into the banking system. Right there. That bank can do $10 worth of lending. And let's say that that bank lends it all to this bank. Let's say he lends all of that, so now it turns into an asset which is a loan to this bank. So this bank then has, this isn’t a demand deposit anymore, this is now a loan from this bank. He has more reserves now, that’s his reserve. But the bottom line is wherever those reserves are, it doesn’t matter which banks they sit in. but they enable every dollar of that increase reserves enables $10 of lending. Right. This bank now can create $10 of checking accounts through lending. And so even though the Federal Reserve talks in terms of interest rates, and I’ll talk a lot more about why they are more focus on interest rates than absolute measures of the money supply. Even though they're talking in terms of interest rates, by performing this open market transactions that in effect lowers the interest rates by increasing the amount of reserves out there. They’re actually increasing bank’s lending capacity. So the amount of reserves, that’s base money or you can almost view it as the liability side of the Federal Funds. The reserve deposits, that’s base money, that’s M0. And you got a multiplier effect for M1, which is the amount of demand deposit. Because in this bank it got more reserve and then it can create a bunch of demand deposits like we learned earlier.
So by saying that they're lowering the rates, they're essentially saying that they're going to perform open market transactions that will inject reserves in to the banking system which will allow them to keep their reserve ratios in line. But make a lot more loans. So significantly increase the M1 and the other broader definitions of money supply.
I will see you in the next video.

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