Learn about The Discount Rate Video

By: Guest More than a year ago

Reply to this Comment

Learn about The Discount Rate

Let's do a little review of what the Fed Funds Rate was. The Fed Funds Rate. And then we can move into something that you probably have heard in the same context and their often confused, and that’s the discount rate. So the Federal Funds Rate and then there's the discount rate. And they are related and they kind of do move together. They are pretty different in their actual implementation. So the Federal Funds Rate, this is a target rate. This is the target rate at which the Federal Reserve wants banks to lend to each others. So let's say that I have, and I won't draw the balance sheet every time now. Now let's have bank 1. See this is bank number 1 and this is bank number 2. And let's say this bank over here has a surplus of reserves. I’ll do that in gold just we can reminisce about the gold standard. So let's say it has a surplus of reserves and bank 2 needs them. Right. And let's say right now that bank 1 is willing to lend it to bank 2 if bank 2 pays bank 1 a 6 percent overnight rate. And let's say that the Federal Reserve, they say, you know what? That’s above our target rate. We want banks to lend to each other for a lower interest rate. So we want to do open market transactions or open market operations to lower this rate. And the mechanics that they do, let's just draw the Fed balance sheet. Do the Fed over here, I’ll do them in magenta. That’s too thin. Wrong tool. There we go. So that’s half of it, then this is the other half. So let's say that this is the Feds current assets and in a couple of videos I’ll actually show you what the Feds balance sheet look like before all of these craziness started and what it looks like now. But that’s the Federal Reserve’s assets, this is their liabilities. And then, their liabilities, we’ll be a little bit smaller than their assets. And they have a little equity. Well their equity is a little different than traditional equity. There really isn’t a lot of upside, you just get a dividend on it. But we won't go into the details there. But the mechanism that the Fed uses to these open market operations, they essentially print money. So what the Federal Reserve would do is they will create some notes or some actual reserves. So these are Federal Reserve notes or as we know them, the dollar bills that are sitting in your wallet. Or the things that could be converted to dollar bills that are sitting in your bank account. The bits and bytes and some computer data base in some place. And they can't create out of thin air, they have to have an offsetting liability. They're offsetting liability are Federal Reserve notes outstanding. This is just saying, hey, we issued this. So if someone comes back to it, we have this liability. And this is issued even though these Federal Reserve note, I’ll circle that in yellow, are issued by the Federal Reserve bank. This is a Federal Reserve. They're back by the full faith and credit of the US government. We've talked a lot about what that means. But needless to say, were just going over the mechanics. So what they’ll do is they’ll take these dollars now and they’ll use these dollars to go buy treasuries from people out in the world. It could be me, it could be my grandfather. It could be even some of these banks. And so let's say that there's somebody is holding a treasury. Let me see if it’s me. I hold a T bill, the Federal Reserve will use that money. Let's say I own a ton of T bills, I'm the richest man in the country. It could even be china. China holds a lot of T bills. They buy the T bills, so then this asset is no longer Federal Reserve notes, it’s now a T bill. I'm writing T bill over that. And then I'm no longer holding a T bill, right, because I sold it to the Federal Reserve bank. I don’t know I sold it to the Federal Reserve bank, I just sold it in the market. I don’t know who bought it, it might have been another guy. It might have been another country. But it happens to be, in this case, the Federal Reserve bank. And now I'm holding reserves. I'm holding money as we know it. I'm holding a Federal Reserve note. And what am I going to do with that Federal Reserve note? I'm going to deposit it in banks, right. And so I'm going to take this Federal Reserve note. Let's say I have a couple of bank accounts where I, whatever, just for the sake of simplicity, I deposit some of it in this bank account. And say I deposit some of it in this bank account. Just for simplicity. So what happens now? Now this guy has more notes to lend out and this guy needs less. So demand has gone down, this guy needs less. So demand has gone down from this guy. So supply has gone up from this guy. Now we know that if you need something less, but people have more of it, the price of buying it or borrowing it is going to go down. So this guy has more of it and this guy needs it less. All of a sudden, this guy is not willing to pay 6 percent to borrow it. And this guy is actually more desperate to off load some of these reserves and get some interest on it. So this guy’s going to lower the rate he’ll charged. And this guy’s going to lower the rate he’s willing to pay and maybe it goes down to 5 percent. And the Federal Reserve can keep buying or selling treasuries to adjust once this happens. They can do the opposite. If they said, well, you know rates are a little bit too low. Let's say, whatever happens rates are 3 percent and the Federal Reserve doesn’t like that, it wants to raise the Federal Funds Rate which is the target rate that banks lend to each other. Then they can do the opposite thing. They can take this T bill, right. This was a T bill and they will sell it. Right. So they’ll take this T bill and they’ll sell it to someone else. Maybe this guy right here. So this guy, he’s got a dollar bill. So he’s dollar bill actually I won't draw it there. He’s dollar bills are going to be sitting in one of these banks. Let's say that he’s dollar bill is sitting in a couple of there and a couple of there. So when the Federal Reserve sells this T bill to this guy. This guy might do a wire transfer to that party or write a check or it doesn’t matter. But either you look at it, these reserves disappear and they go back in to the Federal Reserve. And when they go back to the Federal Reserve, they all set this liability and then the currency essentially disappears. But the real result is that, all of a sudden then demand would’ve gone up because there will be fewer reserves in the system. Demand goes up and then the supply would have gone down because there are also fewer reserves in the system. And now this guy says, well I have less to lend out, I need more interest in order for me to lend it out. And this guys says, wow, I'm more desperate than ever to borrow some reserves. I'm willing to pay more. And so the rates would go up to 4 percent. Now all of these works well assuming a world where banks are willing to lend to each other in some rate. There's some rate in which, this guys says, I'm willing to lend to this guy because I know he’s going to pay me the next day. It’s just a matter of supply or demand. And this tends to be overnight loan. They tend to be very short term loans. So they tend to be very, very safe. But what happens in a world, let me draw the same two banks. So this is bank number 1 and this is bank number 2. And bank number 1 had more reserves, bank number 2 just fewer. Bank number 2 need reserves. Let's say, people are worried about bank number 2. All of their depositors are starting to get scared. And they're starting to pull their reserves out. And we all know that these banks don’t keep enough reserves to fulfill all of their deposits. Actually let me draw a bank number 2’s balance sheet. Let's say this is bank number 2’s balance sheet. They have some equity hopefully. They’ll have some deposits. Let's say all of these are deposits. They have to keep some reserves, right. So that’s an asset. And depending on their reserve requirements, that they’ll have some reserves in case people want to take out their money from their checking account. And then the rest of these are assets that they have invested in the bank. Makes money by making more money on these assets. But it has to pay out in interest. It makes money on that spread. Now what happens if this bank, its condition starts to get a little bit weak? People start to get afraid. And the deposits start to have people go to their ATM, start pulling their money out. And if anything, maybe they’ll start depositing it in to a safer bank or just stuffing it down in their mattresses. Right. This bank says, oh no, all of a sudden I have a liquidity issue. Because, sure, maybe that much people withdraw their money, I have enough reserves to pay that. But then if another guy comes along, then that’s going to deplete my reserves. And then when the next guy comes along, I'm not going to have any reserves left. And this is going to be a full out panic when I told this guy that I could give him his money on demand, and all of a sudden if I can't give the money on demand. Then were going to have this huge banking panic, and then everyone else is going to want their deposits. And then I'm going to have this huge liquidity crisis. In a normal situation like that, I’d say, hey bank number 1 I need some reserve. And just like I did in the first half of this video, this guy would lend the reserves. And then this guy would give this guy interest. But what if this guy is scared of bank number 2 to? He’s like, wow, that guy is in a tough situation. He’s facing a liquidity crisis. I don’t even know what his assets are worth, maybe his assets are actually shrinking. And that’s been happening lately. Maybe he made a bunch of bad mortgage loans. I don’t want to lend to this guy. And this guy becomes a pry of the banking community. No one wants to lend to this guy. But in the same time, it’s in no one’s interest for there to be a run on this bank, because if this guy can't pay one of his depositors. And this is kind of a prime weakness of a fractional reserve system, if there's just one weak link in the banking system and people lose confidence, maybe this guy was the only bad bank out there. And people would start picking all their money out. The first guy who can't get his money back, he’ll going to call up the press and say, my God, the bank’s aren't good for the money. And maybe everyone just run on all the bank. So people don’t know which banks are good, which ones are bad. So to prevent this, the Federal Reserve has something called the discount window. So then we draw the Federal Reserve balance sheet again. And the discount window is essentially a lender’s last resort to the banks. So there's some type of Federal Funds Rate, let's say the Federal Funds Rate is at 6 percent. And in normal environment, this guy would lend to that guy at 6 percent. But let's say that's broken, and this guy is really desperate. He can actually go to the Federal Reserve and borrow directly from the Federal Reserve. So once again these are the assets of the Federal Reserve. These are the liabilities. This is the equity of the Federal Reserve. And the Federal Reserve in this situation now, they will print notes. So Federal Reserve notes or reserves. And these are the notes outstanding liability. And they will lend it to this guy. They lend these notes to this guy. And in exchange, this guy has to give some collateral to the Federal Reserve. So let's say he have some other assets here that are hard to sell. Right, that he don’t want to sell them in a hurry. So he’ll just keep it as his collateral with the Federal Reserve. And these are called repurchase transactions. It’s essentially just your collateralizing the loan. And I’ll do a whole video on what are repo transaction is. But the big picture is, this guy is desperate. No one else is willing to lend the money. So the Federal Funds Rate is now a non-issue. So he goes to the discount window and borrows directly from the Federal Reserve as a lender of last resort. And the rate in which he borrows, the interest that he pays this guy, that is the discount rate. So that’s the rate that a bank pays the Federal Reserve when it can't borrow from another bank overnight. And in general, the discount rate tends to be higher than the Federal Funds Rate. In fact it always is, right. because you don’t want people, if the discount rate is less than the Federal Funds Rate, then you’d always have people using the discount window all of the time instead of borrowing from each other. But we’ll see in future videos, when times get tough, this gets use a lot more. Historically, a discount rate was about a percent higher than the Federal Funds Rate to encourage people to lend to each other or borrow from each other. But in the recent past, the spread has gone down, and now all of the rates are almost 0. But we’ll go over that in more detail. It’s the key differential. When the Federal Reserve talks about setting rates, they're usually talking about setting the Federal Funds Rate. And the discount rate usually moves down with it. But it’s always going to be a little bit higher than the Federal Funds Rate. This is lending of last resort, this is for everyday borrowing between banks to make sure that everyone have a reserve they need or they don’t have too much that they can get interest on it. Anyway, see you in the next video.

Khan Academy

The Khan Academy is a not-for-profit organization with the mission of providing a high quality education to anyone, anywhere.

http://www.khanacademy.org/

Let's do a little review of what the Fed Funds Rate was. The Fed Funds Rate. And then we can move into something that you probably have heard in the same context and their often confused, and that’s the discount rate. So the Federal Funds Rate and then there's the discount rate. And they are related and they kind of do move together. They are pretty different in their actual implementation.
So the Federal Funds Rate, this is a target rate. This is the target rate at which the Federal Reserve wants banks to lend to each others. So let's say that I have, and I won't draw the balance sheet every time now. Now let's have bank 1. See this is bank number 1 and this is bank number 2. And let's say this bank over here has a surplus of reserves. I’ll do that in gold just we can reminisce about the gold standard. So let's say it has a surplus of reserves and bank 2 needs them. Right. And let's say right now that bank 1 is willing to lend it to bank 2 if bank 2 pays bank 1 a 6 percent overnight rate. And let's say that the Federal Reserve, they say, you know what? That’s above our target rate. We want banks to lend to each other for a lower interest rate. So we want to do open market transactions or open market operations to lower this rate. And the mechanics that they do, let's just draw the Fed balance sheet.
Do the Fed over here, I’ll do them in magenta. That’s too thin. Wrong tool. There we go. So that’s half of it, then this is the other half.
So let's say that this is the Feds current assets and in a couple of videos I’ll actually show you what the Feds balance sheet look like before all of these craziness started and what it looks like now. But that’s the Federal Reserve’s assets, this is their liabilities. And then, their liabilities, we’ll be a little bit smaller than their assets. And they have a little equity. Well their equity is a little different than traditional equity. There really isn’t a lot of upside, you just get a dividend on it. But we won't go into the details there.
But the mechanism that the Fed uses to these open market operations, they essentially print money. So what the Federal Reserve would do is they will create some notes or some actual reserves. So these are Federal Reserve notes or as we know them, the dollar bills that are sitting in your wallet. Or the things that could be converted to dollar bills that are sitting in your bank account. The bits and bytes and some computer data base in some place. And they can't create out of thin air, they have to have an offsetting liability. They're offsetting liability are Federal Reserve notes outstanding. This is just saying, hey, we issued this. So if someone comes back to it, we have this liability. And this is issued even though these Federal Reserve note, I’ll circle that in yellow, are issued by the Federal Reserve bank. This is a Federal Reserve. They're back by the full faith and credit of the US government.
We've talked a lot about what that means. But needless to say, were just going over the mechanics. So what they’ll do is they’ll take these dollars now and they’ll use these dollars to go buy treasuries from people out in the world. It could be me, it could be my grandfather. It could be even some of these banks. And so let's say that there's somebody is holding a treasury. Let me see if it’s me. I hold a T bill, the Federal Reserve will use that money. Let's say I own a ton of T bills, I'm the richest man in the country. It could even be china. China holds a lot of T bills. They buy the T bills, so then this asset is no longer Federal Reserve notes, it’s now a T bill. I'm writing T bill over that. And then I'm no longer holding a T bill, right, because I sold it to the Federal Reserve bank. I don’t know I sold it to the Federal Reserve bank, I just sold it in the market. I don’t know who bought it, it might have been another guy. It might have been another country. But it happens to be, in this case, the Federal Reserve bank. And now I'm holding reserves. I'm holding money as we know it. I'm holding a Federal Reserve note.
And what am I going to do with that Federal Reserve note? I'm going to deposit it in banks, right. And so I'm going to take this Federal Reserve note. Let's say I have a couple of bank accounts where I, whatever, just for the sake of simplicity, I deposit some of it in this bank account. And say I deposit some of it in this bank account. Just for simplicity.
So what happens now? Now this guy has more notes to lend out and this guy needs less. So demand has gone down, this guy needs less. So demand has gone down from this guy. So supply has gone up from this guy. Now we know that if you need something less, but people have more of it, the price of buying it or borrowing it is going to go down. So this guy has more of it and this guy needs it less. All of a sudden, this guy is not willing to pay 6 percent to borrow it. And this guy is actually more desperate to off load some of these reserves and get some interest on it. So this guy’s going to lower the rate he’ll charged. And this guy’s going to lower the rate he’s willing to pay and maybe it goes down to 5 percent. And the Federal Reserve can keep buying or selling treasuries to adjust once this happens. They can do the opposite. If they said, well, you know rates are a little bit too low. Let's say, whatever happens rates are 3 percent and the Federal Reserve doesn’t like that, it wants to raise the Federal Funds Rate which is the target rate that banks lend to each other. Then they can do the opposite thing. They can take this T bill, right. This was a T bill and they will sell it. Right. So they’ll take this T bill and they’ll sell it to someone else. Maybe this guy right here.
So this guy, he’s got a dollar bill. So he’s dollar bill actually I won't draw it there. He’s dollar bills are going to be sitting in one of these banks. Let's say that he’s dollar bill is sitting in a couple of there and a couple of there. So when the Federal Reserve sells this T bill to this guy. This guy might do a wire transfer to that party or write a check or it doesn’t matter. But either you look at it, these reserves disappear and they go back in to the Federal Reserve. And when they go back to the Federal Reserve, they all set this liability and then the currency essentially disappears. But the real result is that, all of a sudden then demand would’ve gone up because there will be fewer reserves in the system. Demand goes up and then the supply would have gone down because there are also fewer reserves in the system. And now this guy says, well I have less to lend out, I need more interest in order for me to lend it out. And this guys says, wow, I'm more desperate than ever to borrow some reserves. I'm willing to pay more. And so the rates would go up to 4 percent.
Now all of these works well assuming a world where banks are willing to lend to each other in some rate. There's some rate in which, this guys says, I'm willing to lend to this guy because I know he’s going to pay me the next day. It’s just a matter of supply or demand. And this tends to be overnight loan. They tend to be very short term loans. So they tend to be very, very safe.
But what happens in a world, let me draw the same two banks. So this is bank number 1 and this is bank number 2. And bank number 1 had more reserves, bank number 2 just fewer. Bank number 2 need reserves. Let's say, people are worried about bank number 2. All of their depositors are starting to get scared. And they're starting to pull their reserves out. And we all know that these banks don’t keep enough reserves to fulfill all of their deposits.
Actually let me draw a bank number 2’s balance sheet. Let's say this is bank number 2’s balance sheet. They have some equity hopefully. They’ll have some deposits. Let's say all of these are deposits. They have to keep some reserves, right. So that’s an asset. And depending on their reserve requirements, that they’ll have some reserves in case people want to take out their money from their checking account. And then the rest of these are assets that they have invested in the bank. Makes money by making more money on these assets. But it has to pay out in interest. It makes money on that spread.
Now what happens if this bank, its condition starts to get a little bit weak? People start to get afraid. And the deposits start to have people go to their ATM, start pulling their money out. And if anything, maybe they’ll start depositing it in to a safer bank or just stuffing it down in their mattresses. Right. This bank says, oh no, all of a sudden I have a liquidity issue. Because, sure, maybe that much people withdraw their money, I have enough reserves to pay that. But then if another guy comes along, then that’s going to deplete my reserves. And then when the next guy comes along, I'm not going to have any reserves left. And this is going to be a full out panic when I told this guy that I could give him his money on demand, and all of a sudden if I can't give the money on demand. Then were going to have this huge banking panic, and then everyone else is going to want their deposits. And then I'm going to have this huge liquidity crisis.
In a normal situation like that, I’d say, hey bank number 1 I need some reserve. And just like I did in the first half of this video, this guy would lend the reserves. And then this guy would give this guy interest.
But what if this guy is scared of bank number 2 to? He’s like, wow, that guy is in a tough situation. He’s facing a liquidity crisis. I don’t even know what his assets are worth, maybe his assets are actually shrinking. And that’s been happening lately. Maybe he made a bunch of bad mortgage loans. I don’t want to lend to this guy. And this guy becomes a pry of the banking community. No one wants to lend to this guy. But in the same time, it’s in no one’s interest for there to be a run on this bank, because if this guy can't pay one of his depositors. And this is kind of a prime weakness of a fractional reserve system, if there's just one weak link in the banking system and people lose confidence, maybe this guy was the only bad bank out there. And people would start picking all their money out. The first guy who can't get his money back, he’ll going to call up the press and say, my God, the bank’s aren't good for the money. And maybe everyone just run on all the bank. So people don’t know which banks are good, which ones are bad.
So to prevent this, the Federal Reserve has something called the discount window. So then we draw the Federal Reserve balance sheet again. And the discount window is essentially a lender’s last resort to the banks. So there's some type of Federal Funds Rate, let's say the Federal Funds Rate is at 6 percent. And in normal environment, this guy would lend to that guy at 6 percent. But let's say that's broken, and this guy is really desperate. He can actually go to the Federal Reserve and borrow directly from the Federal Reserve.
So once again these are the assets of the Federal Reserve. These are the liabilities. This is the equity of the Federal Reserve. And the Federal Reserve in this situation now, they will print notes. So Federal Reserve notes or reserves. And these are the notes outstanding liability. And they will lend it to this guy. They lend these notes to this guy. And in exchange, this guy has to give some collateral to the Federal Reserve.
So let's say he have some other assets here that are hard to sell. Right, that he don’t want to sell them in a hurry. So he’ll just keep it as his collateral with the Federal Reserve. And these are called repurchase transactions. It’s essentially just your collateralizing the loan. And I’ll do a whole video on what are repo transaction is. But the big picture is, this guy is desperate. No one else is willing to lend the money. So the Federal Funds Rate is now a non-issue. So he goes to the discount window and borrows directly from the Federal Reserve as a lender of last resort. And the rate in which he borrows, the interest that he pays this guy, that is the discount rate. So that’s the rate that a bank pays the Federal Reserve when it can't borrow from another bank overnight. And in general, the discount rate tends to be higher than the Federal Funds Rate. In fact it always is, right. because you don’t want people, if the discount rate is less than the Federal Funds Rate, then you’d always have people using the discount window all of the time instead of borrowing from each other. But we’ll see in future videos, when times get tough, this gets use a lot more.
Historically, a discount rate was about a percent higher than the Federal Funds Rate to encourage people to lend to each other or borrow from each other. But in the recent past, the spread has gone down, and now all of the rates are almost 0. But we’ll go over that in more detail. It’s the key differential. When the Federal Reserve talks about setting rates, they're usually talking about setting the Federal Funds Rate. And the discount rate usually moves down with it. But it’s always going to be a little bit higher than the Federal Funds Rate. This is lending of last resort, this is for everyday borrowing between banks to make sure that everyone have a reserve they need or they don’t have too much that they can get interest on it.
Anyway, see you in the next video.

Transcription by: Scribe4you Transcription Services