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Finance and capital markets
Course: Finance and capital markets > Unit 8
Lesson 2: Quantitative easingOpen market operations and quantitative easing overview
Basic difference between traditional open market operations and quantitative easing. Created by Sal Khan.
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At1:00Sal said Fed buys treasuries and deposits the money in banks. When Fed buys treasuries, doesn't the money go to the Treasury Department? Doesn't the treasury department need to use that money on payroll and other stuff? How does that money end up in the banks? Who has control over which banks the money ends up in?(5 votes)
Great question. When the Federal Reserve conducts Open Market Operations, they are buying treasuries from investors on the Secondary Market, not from the Treasury itself. So the money goes to these investors, increasing the total money supply.(9 votes)
So the fed funds rate is equivalent to libor, right? Also, what is the word that Sal says at3:00? Thank you(2 votes)- They are similar, but not the same. The fed funds rate is a target rate that the fed sets for what US institutions will lend to each other on an overnight basis. The Fed uses open market operations to try and control this rate.
Libor is a market rate based on what major banks in London are lending USD to each other at. Libor is also calculated on many different time frames, such as 1 month Libor and 3 month Libor, whereas the fed funds rate is strictly an overnight rate. Libor is also calculated in about 10 different currencies, whereas the fed funds rate is just for USD.
At3:00Sal says "mortgage backed security."(5 votes)
- This may be a weird question, but QE, as Sal describes it, means that the FED funds rate is at 0...how can the Federal Funds rate be at 0? What does that mean? My understanding was that this %age represents the overnight borrowing rate between banks, but why would banks lend to each other at 0%?(3 votes)
This is a good question. The banks may not want to lend at that rate, however, due to federal intervention, that is the only way they can balance their system (they don't want too much or too little cash). The banks also may need to get rid of extra cash (or get some) and then get it back (or give it) when they need it.(1 vote)
- why the fed cannot keep buying treasury bills to pump more money into the economy after the fed funds rate hit zero. i mean, if they want, can they?(2 votes)
- They can and they have. That's what "quantitative easing" is.(2 votes)
- I understand why and how the regulation of the fed funds rate work and why you would to do it in the short term. If the money supply is bigger everyone needs less of it and the rate in which banks lend to each other decreases since in one hand the ones that would need to borrow will need less and therefore are willing to pay less interest on it and for the other hand the ones lending would have to lower their interest rates in order to be able to lend. More money means more investment and in a simplistic way means more wealth creation. So far so good. Now, what I don't fully understand or at all is what is the point of manipulating the yield curve in the long term and how buying assets will decrease the yield curve. If I, being the feds, buy corporate debt why does the interest of that debt will go down? Or why is that good for economy? The interest being lower allow companies to invest more and create more wealth? Is that the point in the example I gave? I am sorry if the question is confusing... I am confused so... did the best I can to explain. Thanks!(1 vote)
- Why in open market operations does the central bank buy only short-term treasury bills? I mean, also in the case in which it buys, say, 30 year TB, people would still put that money in the banks increasing bank reserves and decreasing the demand for them. Is it because people that had money invested in such long term assets would more likely reinvest the money in other assets decreasing again reserves or are there other reasons? Thx(1 vote)
- I now understand how FED controls the Fed Fund Rate and conduct QE, can someone explain to me why FED wants to do this? and under what circumstances they do this?(1 vote)
- They expand the money supply to try to combat economic weakness and they contract it when they are concerned about inflation.(2 votes)
What does Sal mean by "smoothing" over the market at3:07?(1 vote)- Calming the waters, so to speak. Taking the waves out of the economy.(1 vote)
- Can the Fed run out of money to buy the treasuries and other securities ?(1 vote)
- At0:15, Sal mentions the fed prints money to conduct open market operations, but can the fed use its own reserves to conduct the open market operation as well?(1 vote)
- The Fed doesn't actually print currency to conduct open market operations. They create reserves and then use those reserves to buy assets in the open market.(1 vote)
1:00Video transcript
When the Federal Reserve
does traditional open-market operations, what they
do is the Fed over here will literally print money. So it prints money. It doesn't necessarily
have to be cash, it could be electronic money. And it uses that money to buy
usually short-term treasury securities in the open market. That's why it's called
open market operations. So in exchange it gets
treasury securities. Now, the whole
purpose of this, it does increase the
demand for treasuries, and, therefore, increases
the price on treasuries and lower the interest rate. But the main point is it
takes this printed money, and it puts it in
the banking system. Because it buys treasuries just
from people, or from banks, or institutions, and then
those people take that cash, that they just got
for these treasuries, and they'll deposit it in banks. So they'll go and they'll
deposit it in, maybe, Bank 1 over here, then
over here in Bank 2. And since there's more
money in Bank 1 and Bank 2, you have the supply
of money going up, and also the demand for
reserves is going up. This cash right here,
these are reserves. So you have the demand
for reserves going down. Maybe before this money
entered the system, maybe Bank 2 is running
low on reserves. But now people have
deposited money in Bank 2, so Bank 2 doesn't
need it as much. And if you have the
supply of money going up, you have the demand
for money going down-- where in particular I'm
talking about reserves. I'm talking about
base-money right over here-- then the overnight
borrowing rate between banks will go down. The price of money will go down. And that's what the
federal funds rate is. It's the target rate. So I'll say fed funds rate. It's the target
rate that the Fed sets for the overnight borrowing
of reserves between banks. That's the federal funds
rate, and it will go down. And that's how the Fed tries
to set the federal funds rate. Now, fast forward to a
situation like we are right now. And the federal funds
rate is already at 0, but the Fed still wants to pump
more money into the economy and it wants to do it
in a more directed way. So now what it's doing,
it's still printing money, but it's using that money
to buy other things. It could buy longer-term debt. So it could buy longer
duration treasuries. So things that are
maybe going to, maybe 10-year treasury bonds,
or further out than even that. Or it could even buy
completely different assets. It could maybe buy
mortgage backed securities. And the point here isn't just
to increase the money supply. The point in quantitative
easing is, maybe, to kind of smooth
over what's happening in certain parts of the market. So if they think that there's
a logjam in the mortgage backed security market, that's why
they're participating there. So this right over here,
that is quantitative easing.