Banking 15: More on the Fed funds rate

Let's a review a little bit of what we've gone over. And I think it helps to see the whole process again, just so it really sinks into your brain and I've drawn the banks in a different arrangement this time. But just as 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 these could actually be federal reserve notes-- and we all know that as dollars or cash. This is another bank with slightly more reserves. And 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 it directly with the demand deposits or the liabilities of this bank. Most banks have other liabilities, but I've just assumed that all of them are demand deposit. That's this magenta square here. And of course their equity is the blue right there. Let me make sure I have it. That's their equity. And of course if these are either federal reserve notes or these are deposits within the reserve bank, those are of course liabilities for the reserve bank itself. So let me draw a line from there to there. This is a liability for the reserve bank. If these were deposits, if these were essentially demand accounts with the reserve bank, then we could even divide them up a little bit and separate-- OK, this guy has this much-- I don't know if you can see that. That color's not so good. This guy has this much. This guy has this much, but if these are all federal reserve notes, they kind of all come out of the same bucket. 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 talk about in terms of interest rates. They always say, our target interest rate or the federal reserve rate is now going to be X. 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 extra reserves, this bank has a little bit less reserves. So there's a couple things that this bank could do with these extra reserves. It could either do some more lending-- so it could actually-- because it's reserve-- let's say it's at a 20% reserve ratio. This ratio to this is 20%. And it can be as low as-- it would feel comfortable being at a 15% reserve ratio. So roughly a fourth of its reserves could be used for doing something else. And what could it be used for? So let's say this portion of its reserves could be used 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 wants some reserves and then it would add it up on here. The last video, I filled in the reserves down here, but actually they're not replacing other assets. They would have actually just been added to the balance sheet of the bank. So I should have drawn them on top and I'll do that a second. But the other option that this bank could do is that they could actually do more lending. Since the reserve ratio is higher than they want, they can actually create checking accounts like we saw on the last couple of videos. With that said, let's say that 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 with it 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 right here. The current rate is 6%. Now the federal reserve says, you know what? I would like to expand the money supply. And they don't say it directly. They don't tell us in our newspapers. They don't make a press release saying, 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 federal funds rate to 5%. So let's say they want a federal funds rate-- they are setting to be 5%. The governors of the federal reserve bank sit together and Bernanke comes out and says, we're lowering the federal funds rate to 5%. So what that 5% percent means is that their target rate is now 5%. So this is a target. So what they're saying 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 being willing to pay 6%, he'll be willing to pay 5%. Remember, on any transaction, both people have to agree on it. So how do they do that? And I think we've we're reasonably familiar with the mechanics now. So what the federal reserve could do is 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. These are notes outstanding, right? See, I should've done all this in this darker shade of green. 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. 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. What they say is, we're 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 it from Russia, they could be buying it from me, they could be buying it from my uncle. Regardless of who they buy it from-- let's say they buy it from someone in the U.S. so that we don't get confused right now. Let's say they buy it from my uncle. So this is my uncle. Let me see if I can draw him. 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, well, I'm not going to sell it now, but if someone's 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 it to the federal reserve. He just sees selling it to 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 that. So all of a sudden someone goes out there and is willing to pay a slightly higher price for these treasury bills, these IOUs from the government and he's like, oh, fine. Yeah, that's a good price. I'm going to sell them to whoever's buying it. It turns out that it's actually the federal reserve that's buying it. So the federal reserve all of a sudden has-- my uncle would be a big time operator if the federal reserve only bought from him. He would have to have hundreds of billions of dollars of these things. And he doesn't have his IOU anymore. What does he have right now? That IOU is now exchanged for a dollar bill or hundreds of billions of dollar bills or reserve deposits at the federal reserve-- all the same, but just to keep the abstraction solid for right now, we'll keep it in terms of dollar bills. So his IOUs he's sold in exchange for these dollar bills. And what does he do with them? This is hundreds of billions of dollars. He's not going to stuff it all into his mattress. He's going to deposit it into the banking system. So maybe he gives a little bit to this bank up here. This is a slight mistake that I did in the last video. I was adding it below, but it's not replacing other assets. It's new assets. So let's say he put some of it here-- my uncle after he sold his treasuries. Let's say he put some of it in this bank-- or maybe it's a bunch of people's uncles and they all don't go to the same bank. Let me do that in a slightly different shade of green, just so you know this is-- I'll do in blue. Just so you know, this is a new deposit, but it's close enough to green that I think you get the idea. And of course, he has an off setting-- his checking account if he didn't have one already. Now he has one so their liabilities increase a little bit. So a couple of things will happen. Just in terms of how does this affect the rate that they're charging to each other? Well, now all of a sudden, this bank's reserve ratio's gotten a little bit better. His assets and his liabilities increased, right? His assets increased by the amount of my uncle's deposit, but so did the liabilities because he's had the demand deposit. But it came in a ratio of reserves to demand deposit 100%. So this would have improved his reserve ratio. If you now take the ratio of this height to this height, it's not going to improve a little bit, right? So now he doesn't need money-- this bank doesn't need money as bad in order to improve its reserve ratio. And likewise, this bank now even has an even better reserve ratio. He already had more reserves than he needed and now he got even more. He has an even better reserve ratio. So now this guy's demand for reserves is a little bit lower and this guy's supply of reserves is a little bit higher. So this guy's 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 actually lend off some of his reserves. So just by increasing the supply of reserves and decreasing the demand of reserve, the current rate-- if the fed does this appropriately-- will go to 5%. And let's say it only went to 5-1/2%, then the fed will keep doing this and then it'll go to 5%. If it goes too far, if it goes to 4-1/2%, maybe the fed will reverse the transaction. The fed will actually go out there and sell these treasury notes. But I also want to make it clear that the point of this-- although it does affect the interest rates and that's what the federal reserve always talks about in terms of their target rates-- 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, a 10% reserve ratio, every dollar that is injected into the banking system right there, that bank can then do $10 worth of lending. Let's say that bank lent it all to this bank. Let's say he lends all of that-- so now this turns to 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 reserves. I shouldn't be doing it in that purple color. I should be sticking to green. But the bottom line is, wherever those reserves are, doesn't matter which banks they sit in, but every dollar of that increased 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 about why they're more focused on interest rates than absolute measures of the money supply-- even though they talk in terms of interest rates, by performing these open market transactions that in effect lower the interest rate by increasing the amount of reserves out there, they're actually increasing banks' lending capacity. So the amount of reserves-- that's base money-- or you could almost view it as the liability side of the federal funds, the reserve deposits. That's base money. That's M0. And you get a multiplier effect for M1, which is the amount of demand deposits because in this bank it got more reserves 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 into 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 then the other, looser, the broader definitions of money supply. I will see you in the next video.