♪ [music] ♪
- [Tyler] The Federal Reserve is one of the most powerful players
in the economy, because it controls the supply of money.
And through that control,
it influences aggregate demand in the economy.
Sometimes the Fed wants to increase aggregate demand,
and at other times, decrease aggregate demand.
But how does it do this?
Well, the Fed uses the money supply and interest rates
to affect the amount of loans and credit.
Let's briefly recap how the Fed did this
in the old days, before 2008.
Now in the old days,
the Fed typically conducted monetary policy
by targeting the federal funds rate with open market operations.
What's the federal funds rate?
Well, the federal funds rate is the overnight lending rate
from one major bank to another.
Yes, banks do loan money to each other.
Recall that banks make money by taking in deposits
and using those deposits to make loans.
Banks cannot lend out all of their deposits,
because they need some funds on hand
to settle transactions with other banks,
to give to customers,
and also to satisfy the Federal Reserve
which requires, by law,
that banks hold a certain percentage of their deposits as reserves.
Prior to 2008,
the banks didn't have much incentive
to keep excess reserves --
that is, reserves above and beyond what was required by law --
so the banks tried to keep reserve holdings relatively low.
Sometimes banks found themselves with too few reserves
to meet the requirements of their customers or of the Fed,
so they borrowed reserves from other banks.
Borrowing and lending of reserves in the federal funds market --
that established an interest rate, the federal funds rate.
And now we get to our second concept,
open market operations.
The Fed affects the federal funds rate
by performing open market operations,
and those we define as the Fed using its reserves
to buy and sell government securities,
typically Treasury bills.
And the Fed is making those trades with banks.
So if the Fed wanted to lower interest rates,
it would buy T-bills from banks,
thus increasing the supply of bank reserves.
We call that an expansionary open market operation.
The new reserves would allow banks to make more loans,
thus stimulating the economy,
making it easier to start or expand new businesses
or easier to get a mortgage.
This increase in reserves,
it also would lower the opportunity cost
of banks loaning those reserves out to other banks,
and that, in turn, would lower the federal funds rate.
Thus, prior to 2008,
the Federal Reserve used open market operations
to change the supply of reserves until the federal funds rate
was more or less at the level the Fed wanted.
This figure shows excess reserves prior to October, 2008.
Note that banks were typically holding
about 2 billion dollars in excess reserves
at that earlier period in time.
By the way, if you're wondering, that big spike in 2001?
That was a response to the terrorist acts of 9/11,
when the Fed made tremendous amounts of emergency cash available
to the financial system.
Now, at that time, demand deposits in the system
often were around $300 billion,
so excess reserves were really quite small relative to deposits,
less than 1%.
Now, going back to the longer story,
keep in mind that while the Fed has considerable control
over the federal funds rate,
there are lots of different interest rates in an economy.
In theory, these interest rates to some extent move together,
and they're affected by the interest rate
the Fed does influence.
In practice, those connections can be looser or tighter,
and that will influence how good a job,
or how exact a job the Fed does in steering the economy.
How exactly does this work in practice?
Well, the Fed Chair announces a change
in the target federal funds rate.
That signals the Fed will buy and sell T-bills
until the federal funds rate adjusts to the new target.
It's interesting, though -- usually the federal funds rate
adjusted to the Fed's announced level very quickly,
sometimes well before the Fed
even conducted the open market operations at all.
In fact, the Fed's communication is another important tool
the Fed has to influence the economy.
For instance, the Fed has very important psychological effects
on the market,
through its talk, its posturing, and its announcements.
Of course, the Fed had other instruments
to influence the economy before the Great Recession,
but we're focusing on the most important tools.
In summary, before the Great Recession
the Fed usually changed the supply of bank reserves
to affect interest rates and the money supply,
and thus it could influence
credit conditions and aggregate demand.
That was then.
Now, for our next video,
we're going to consider the contemporary procedures.
- [Narrator] You're on your way to mastering economics.
Make sure this video sticks by taking a few practice questions.
Or, if you're ready for more macroeconomics,
click for the next video.
♪ [music] ♪
Still here?
Check out Marginal Revolution University's other popular videos.
♪ [music] ♪