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More on quantitative easing (and credit easing)

Understanding the difference between quantitative easing in Japan and the United States. Created by Sal Khan.

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  • old spice man green style avatar for user TerryMHogan
    At about Sal talks about how the liabilities side increases right along with the asset side. Is this just the liability of the money printed, because it's "Backed by the full faith and credit of the U.S. government"? Because it's not really a liability in the sense that they'll have to pay out the money to someone is it?
    (7 votes)
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    • aqualine ultimate style avatar for user Abdulaziz.Saja
      Sal explains this better in the "Banking and Money" section. He delves deeper into the workings of the Fed and how Fed Notes (US Dollars) were created and how the currency got off the gold standard.

      But yes, what you said is true. If we were still using the gold standard then this would simply mean that these notes are backed by gold and that they are considered a liability since anyone carrying these notes can go to the Fed and redeem them for a certain amount of ounces of gold. However, we are off the gold standard and thus these notes are backed by "Backed by the full faith and credit of the U.S. government" and that essentially means that it is backed by the US governments power to tax people and meet its debt. And also, that you have faith in Tim Geithner and Ben Bernanke to not print too much of it so as to lose all of its value. Ironically, this is exactly what they are doing...
      (14 votes)
  • leaf green style avatar for user Pharunyu Phuengkanthai
    What are the benefits of having lower yield curve for long-term bonds/securities? I understand that if the Fed Fund Rate is lower, the cost of financing for businesses is lower, hence more productivity.

    1) with lower yield, aren't those long-term investments less attractive? If they are so then, doesn't it mean that there will be less capital financing these investments, resulting in lower production?

    2) and how does 'mortgage market (MBS) become a little bit looser, a little bit more liquid' by this? And how is it beneficial to the economy?
    (4 votes)
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    • piceratops ultimate style avatar for user Darmon
      As you said, the FED lowers interest rates when productivity is low, so they can try to increase it. The reason for this is that the supply of money in the hands of lenders goes up, so the cost to the borrowers (businesses) goes down. Although lower yield to the lender makes them less likely to lend, it also means that the lender will have a larger supply of money that they really want to lend out, so they don't mind charging less. To answer your second question, when the FED buys MBS, they raise their price and demand, and thus lower their yield. The yield in this case is the mortgage payments from the borrowers (homebuyers), so lowering the yield of MBS also lowers the cost of housing. The FED would want to do this when housing gets too expensive because lenders are charging too much interest. Hope that was helpful! :)
      (4 votes)
  • old spice man green style avatar for user Jacinto Cho
    When the Fed prints money they increase the asset side of the balance sheet because they have more cash. But to who does the fed owes that cash, who is the owner of the liabilities (notes outstanding ) that appears at the right of the balance sheet?
    (4 votes)
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    • blobby green style avatar for user mpdunson
      This question was 7 years ago so I'm sure you've figured it out or moved on by now, but in case some one has the same question the answer is whoever has possession of the dollar bills.

      That's why the Federal Reserve is able to print money, because as long as they're in possession of the money they are both the lender and debtor of the federal reserve notes. Their equity doesn't increase. They don't make money out of thin air.

      That is why the Fed can destroy its money and not blink an eye, but if you destroyed your money it would upset you, because money can only be an asset for you, not a liability. However, the Fed would never give the money to charity, because then the bills would be in circulation and so it would no longer have the dollars as an asset, but it would still have the bills as a liability. Hence, the FR's equity would decrease. The Federal Reserve is a non-for-profit its equity should stay relatively the same. I guess something like real estate prices of the land the Federal Reserve banks are occupying may fluctuate, but this isn't the Fed intentionally making a profit. They're not investing in real-estate they just need some land to place their bank.

      So how are the bills a liability? Because the Fed use to have to give the value in gold for any dollars returned to one of its banks. Similarly if someone deposited Gold in one of the Federal Reserve Banks the Fed would give the value in dollars of the gold to the depositor. These federal reserve notes (look at the top of your dollar bills) are bank notes. The bank is the federal reserve that's why the top of your 20 says federal reserve note. A bank note is an IOU from the bank. Depositors gave the Federal Reserve "real value" GOLD and the Federal Reserve gave the depositors an IOU the federal reserve notes.

      People got use to transacting with these bank notes, because they knew the Federal Reserve was good for it. Then president FDR stopped allowing people to trade in their money to Federal Reserve for Gold, but "no one" cared because you can still transact with it to get goods and services. There was still a ratio to gold in reserve to dollars in circulation though - hence a fractional reserve. This ratio could change, but it was changed through regulation. This gave some peace of mind that the government wasn't going to print off unlimited dollar bills and totally dilute its value (one cause of inflation).

      However, president Nixon came along and got the US off the gold standard. That meant that gold reserves wouldn't influence how much money is printed. Instead, you can trust that hyper-inflation won't happen, because the Federal Reserve only purchases "sure things" like US Treasuries. We can be "sure" that the US Treasuries will be paid back, because the U.S. Government can tax its citizens or if worst comes to worst bring soldiers to your door and take the equivalent value of the treasury in "stuff" - for instance GOLD.

      As long as the Fed is always investing in "sure things" then it isn't creating money out of thin air, because eventually these treasuries reach maturity and the money returns right back to the Fed with profit. The profit goes to the the treasury and the Fed can decide to either destroy the original money or buy new treasuries.

      However, with Quantitative Easing the Federal Reserve stopped investing in "sure things", because it wanted to "solve" the housing market/economic crisis. It purchased AAA corporate debt and AAA mortgage-backed securities. However, if you keep watching you'll realize those ratings maybe shouldn't be trusted.

      The securities ended up making up what the Fed paid for it with interest, but that doesn't change the fact that it over-paid for it. The Fed paid book-value(old data) for these mortgage-backed securities, but on the open market it could have gotten it for much cheaper. Hence, wealth was destroyed, but then it was created again, because they happened to make money. However, imagine if the FR had put 10k in lottery tickets. Obviously wealth is being destroyed, because the expected return on the lottery tickets is definitely under 10k - for example 2k. Now let's say one of the lottery tickets happen to win the jackpot and get 20 million dollars. Clearly wealth is created, but does that justify the initial investment. No, the Federal Reserve just go lucky. Similarly if some shady banks start off loading some smelly mortgage-backed-securities at book value 6 months ago to the FR, but current market price for these securities is 10% of that price it doesn't matter if the securities end up making more than book value once they reach maturity, because the Fed still overpaid for the securities. The securities could have just as easily gone in the opposite direction; hence, the market price.

      This is why it was considered a bailout, because in the free-market fatter and less efficient banks and corporations would have died, but the fitter more efficient banks and corporations would have survived. However, with the FR intervening we kept the fat and we created a moral hazard. By bailing out the risk-taking banks we set a precedent. Risk-taking use to come at cost. Now if you are prudent then you lose, because if bad things happen the risky banks and corporations get bailed out and are still solvent like you. However, if good things happen you get crushed by the risky banks and corporations because higher risks often come with higher rewards.
      (1 vote)
  • blobby green style avatar for user raghav.kheria
    Why cant the FED buy treasuries directly from the government?
    (3 votes)
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    • leaf green style avatar for user Ryan
      The Fed cannot legally directly fund the treasury. But, there is a clause in the Fed act that allows them to essentially buy anything in a time of crisis. So, if things got bad enough, they could probably get away with it.

      Many other countries have central banks that buy debt directly from their treasury. It's unknown if the USA's self imposed constraint makes any difference.
      (2 votes)
  • starky ultimate style avatar for user Sudhanshu Sisodiya
    -- I still fully don't understand the concept of "notes outstanding"
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      A dollar bill is basically an IOU from the Federal Reserve. So, when the Federal Reserve prints dollars, it is actually creating IOUs which will need to be redeemed some day. So, those Federal Reserve Notes that have not been redeemed are in fact liabilities of the Federal Reserve, and constitute the Notes Outstanding portion of the Fed's liabilities.
      (2 votes)
  • old spice man blue style avatar for user Manan Arora
    I cannot understand how decreasing the yield of yield curve would benefit the economy?
    (2 votes)
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  • aqualine seed style avatar for user shanegadallah
    At , Sal mentions that when the fed buys long term treasury debt it reduces the yield curve for long term treasuries. Doesn't the treasury yield curve measure the interest the fed pays on treasury securities? Why would buying back long term treasury securities from the market reduce long term federal interest rates?
    (1 vote)
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  • blobby green style avatar for user rsjha1989
    How does Fed buying mortgage backed securities or other similar securities lead to lower interest rates on such instruments?? As I understand, a spike in demand of a particular debt instrument should in fact lead to higher interests rates. I cannot understand how interest rates on such instruments will get reduced.?
    (1 vote)
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  • blobby green style avatar for user rodrigues.olumide
    So that means in 30 years the AAA bonds, MBS etc that were bought would have to be bought back. Is it by the same people the Fed bought them from or they auction off?

    Also what if there are improvements in the economy before the 30 year maturity, say 5 years, and the Fed likes what they are seeing. Is the buyback optional for the lender or mandatory in that 5 year period?!
    (2 votes)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      When this video was made the economy of the USA wasn't performing optimally. To improve the situation the FED bought the AAA bonds, the MBS, etc. They want to keep this up only for as long as the economy performs suboptimal. Once the economy starts performing better the FED will probably sell these AAA bonds, MBS, etc to make sure the economy doesn't overheat. It's pretty likely this will happen in five years or so, so yes, the FED will sell the bonds once they like what they see. Since it's conventional in the financial market you buy and sell stuff on the market without really caring who the other party is the FED will probably sell their assets on an auction.
      (3 votes)
  • male robot donald style avatar for user harry park
    Why are quantity of bank reserves the liability of the FED?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      Bank reserves are deposits at the fed. Deposits are liabilities for banks. They are money owed to someone else. When a bank takes in a cash deposit, two things happen on the balance sheet, not one. On the asset side, cash increases. On the liability side, deposits increase. Since both sides increase by the same amount there is no effect on equity.
      (2 votes)

Video transcript

To get a better understanding of quantitative easing in the American context, especially the context that Ben Bernanke is talking about, I want to read this quote from a speech that Ben Bernanke gave at the London School of Economics on January 13th, 2009. So this is shortly after a lot of the craziness of the financial crisis was happening but it was still going on. And he's saying, "Our approach, which could be described as 'credit easing' -- resembles quantitative easing in one respect." He's saying it's not quite quantitative easing, although it really is. "It involves an expansion of the central bank's balance sheet." So just to understand what he's talking about, the central bank, it has liabilities and assets, like any corporation, and they have to, the liabilities, plus the equity has to match up to the assets. Just for simplicity, let's just have the assets and the liabilies lining up together. So let's say that this is the central bank's balance sheet right over here. This is their current assets, and let's say that is is their liabilities over here, so liabilities, and then this is their equity, although the federal reserve's equity is a little bit strange, it's not like traditional equity, that they get all the excess profits and all of that, all the excess profits actually go to the US government. But when the fed prints money, what they literally do is that they create offsetting liabilities and assets So when they print money they'll, so literally let's say that they're printing some money right over here, so that's money that they're printing, so this is literally, it would be federal reserve notes being created, so these are notes, which are essentially dollar bills. So these are dollar bills right here being printed, either physically or electronically. And then they have an offsetting liability which is just notes outstanding, which is literally saying that hey, these are notes that we've created. Notes outstanding is the other side of the balance sheet. So, just to parse the statement, when he says, "credit easing resembles quantitative easing in one respect it involves an expansion of the central bank's balance sheet." So this is the expansion of the central bank's balance sheet. Which is essentially the same thing as printing money. And the federal bank will get these notes into circulation by going out into the market and buying assets. Traditionally, when the fed is more focused on short-term interest rates, on overnight borrowing rates between banks, it will use these to buy shorter-term debt that increases the amount of currency out there the amount of dollars out there, and so it will lower the interest rate for people buying and selling dollars, or I should say borrowing and lending dollars, not buying and selling. Borrowing and lending dollars, the overnight rate for banks will go down because there's more dollars out there, the cost of borrowing them will go down. That's normally what the fed is concerned about. And they're saying, look, quantitative easing is just this idea of expanding that balance sheet. Let's keep reading: "However, in a pure quantitative easing regime, the focus of quality is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidential." So he's saying in traditional quantitative easing, the central bank says look, I just care about printing money I just care about printing money, So their liabilities increase accordingly. So this is notes outstanding again, And the height here is proportional to how much money they print, so maybe this is another trillion dollars they're printing. But what the federal reserve is saying, in traditional quantitative easing, all the central bank cares about is printing this money and getting it out there into circulation, and they don't really care what they're using this money for. So whenever they get this money into circulation they do go out there and they do buy assets usually treasury assets, and then they say even, "Indeed, although the bank of Japan's policy," -- so he's comparing relative to what Japan did when they kind of faced deflationary crisis. "Indeed, although the bank of Japan's policy approach during the quantitative easing period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves." So you're saying look, the Japanese were trying to fight a deflationary bank crisis, they kept printing money so they kept increasing the liability side of their balance sheet, they kept printing money and they did use this money for a bunch of stuff, they did use that money to go buy a bunch of assets, but their focus of their intervention was just, how much did they print? They didn't really care, they didn't really engineer where that money went to. They really weren't trying to change what happens in the markets that they were participating in. Let's keep reading what the fed is saying. "In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses." So what he's saying is that, we are mechanically doing the same thing that Japan did, we're increasing our balance sheet, which is analogous to printing money And we are also buying a bunch of stuff, just like Japan did, Japan had a multifaceted approach, that's how they put the money into circulation, but what Bernanke is saying is that our approach isn't just focused on the amount of cash that we are printing, our focus is where are we putting that cash toward, how can we use this cash that we printed to kind of, provide liquidity, to ease up things in certain parts of the economy. To understand what he's talking about, let me draw a yield curve right over here. Let me draw this yield curve right over here, so this is maturity on the horizontal axis, and this is yield, and I'm gonna draw the yield curve for treasuries. So let's say the short-term overnight borrowing for, let's say, let's do the yield curve for treasuries, maybe it looks something like this. So short-term interest rates are already pretty darn close to zero, and maybe you know this is some, I don't know what percentage, maybe this is like 4% or something. It's not accurate, but just gives you an idea. So this is the treasury yield curve. Now you could also have a yield curve for other types of debt. Maybe you have AAA corporate debt, a very safe corporate debt, a perceived safe corporate debt, but it's not quite as safe as US treasuries, so maybe it's yield curve might look something like this and this difference, for any maturities, maybe this is a 10 year, this is 10 year debt right here. This difference between this AAA corporate debt and the treasury, that is the yield spread. And maybe the fed is able to, through intervention, first they're able to print money, normally they buy shorter-term debt, maybe they start buying longer-term treasury debt, and maybe that helps get the yield curve, for longer-term treasuries down a little bit. Helps bring it down. But maybe the AAA corporate debts don't react, maybe the spread doesn't stay constant maybe the spread widens. Maybe the same thing for other types of debt. This is highly rated mortgage backed securities, maybe they have a slightly higher interest rate. And once again, even though the treasury interest rates are coming down, while they're intervening because of all the craziness that is happening in the economy, the spread between treasuries, and AAA mortgage backed securities, or the spread between treasuries and AAA corporate debt that widens, or another way to think about it is the treasury interest rates are coming down while these things aren't following it, so what Ben Bernanke is saying, look we are doing quantitative easing, we are printing money and we are using that money to go buy things in the economy and we're increasing the amount of cash that there is in the economy, but our point isn't to increase the amount of reserves, or increase the amount of cash, because it's really not changing the behavior of banks. What we are going to do is go buy things like highly rated mortgage backed securities, or things like commercial paper, AAA corporate debt, so that those things, the interest on those things goes down. Obviously if someone is willing to pay more for a certain amount of debt, and I've gone over this in another video, maybe it's not so obvious, then the interest rates on it will go down. And so what they're doing is, what Bernanke is saying, is he cares more about what winds up on the asset side of the Fed's balance sheet, because it takes these dollars that it printed, and goes and buys other stuff, and it wants to put some mortgage backed securities over here, it wants to put some AAA corporate debt over here. And maybe it also does some longer term treasury securities, or whatever else.