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.