GMAT: Data sufficiency 1

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Kind: captions
Language: en

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Let's do some data sufficiency
problems.

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So the first problem, problem
number one on page 278.

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It says, how much is 20%
of a certain number?

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So we want to know
20% of a number.

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Let me just call that x.

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So what is that?

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So the first data point they
give us is that 10% of the

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number is 5.

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So we could say that 10%
times x is equal to 5.

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Or another way we can just
write that is 0.1

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x is equal to 5.

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And then the second data point,
I guess you could call

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it, is 40% of twice the
number is equal to 40.

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So 40%, 0.4 times twice the
number, so times 2x, right?

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We chose x as our number--
is equal to 40.

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So what we have to figure out
is do either of these data

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points allow us to
figure out x?

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Or maybe we need both of them.

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Or maybe we can't figure it
out even with all of this

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information.

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Well, this is a simple
linear equation.

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A very easy way to think about
it is you could multiply both

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sides of this by 2, both
sides of the equation.

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And you end up with 0.2 times
x is equal to 10.

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Well, that's the same thing
is saying that 20% of

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x is equal to 10.

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So statement one alone is all
we need to figure out this.

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Let's see what statement
two gets us.

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So if we simplify this
expression just a little bit,

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we get 0.4 times 2.

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We have 0.8 times x
is equal to 40.

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And here, instead of multiplying
both sides of this

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equation by 2, we could divide
both sides by 4, right?

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Because we want to
get 20% of x.

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This is 80% of x.

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So if we divide both sides of
this by 4, we get what?

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We got 0.2 x is equal to 10.

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There you go.

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20% of x is equal to 10.

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So either of these alone are
enough to solve that problem.

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And I always forget what the
letters are, but I think that

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is statement d.

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Each statement alone
is sufficient.

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All right.

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Problem number two.

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I don't want to waste too
much time on that.

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And I'm trying to do this in
real time without looking at

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the answers, because I really
want you to get a sense of how

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someone thinks about this
if they've never

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seen the problem before.

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And so I'll ask you to bear with
me a little bit because

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maybe I'll get a
problem wrong.

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And maybe that'll be instructive
if I do.

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OK, They say a thoroughly
blended biscuit mix includes

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only flour and baking powder.

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What is the ratio of the number
of grams of baking

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powder to the number
of grams of flour?

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So we want to know the ratio
of baking powder to flour.

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That's what we need
to figure out.

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Now statement number one, they
tell us exactly 9.9 grams of

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flour is contained in 10
grams of this mix.

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soon.

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So if there are 9.9 of flour,
and there's exactly 10, how

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much baking powder is there?

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Well, baking powder is going
to be equal to 10 minus the

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amount of flour.

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So it's going to be what?

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0.1 grams. 9.9, we could say
that that is equal to flour.

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So we could easily, just using
this statement, figure out the

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ratio, right?

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The ratio of baking powder to
flour is 0.1, because we just

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took 10 minus the amount
of flour, to 9.9.

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Or you could say, it's 1:99,
whatever, however you need it.

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But that's what's fun about
these problems. You don't have

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to figure it out.

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We just have to say we
could figure it out.

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So one is enough by itself.

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Let's see what statement
two tells us.

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I'll do it in a slightly
different color.

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Let me scroll down
a little bit.

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Statement two says,
exactly 0.3 gram.

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I think that's an error
in the book.

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It should be grams. Exactly 0.3
gram of baking powder is

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contained in 30 grams
of the mix.

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So if we have 0.3 baking powder,
that's grams, and it

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tells us there's 30
grams of the mix.

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So how much flour do we have?

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What's 30 minus 0.3
is equal to what?

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It's equal to 29.7 flour.

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And so, once again, we can
easily figure out the ratio of

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baking powder to flour is
0.3:29.7, which is, once

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again, 1:99.

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But we didn't have to
figure that out.

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We just know that
this is enough.

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So once again, we know that
d, each statement alone is

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sufficient, unless I
missed something.

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All right.

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Problem number three.

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Let me scroll down
a little bit.

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What is the value of the
absolute value of x?

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So they want to know the
absolute value of

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x is equal to what?

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And the first statement, they
tell us is that x is equal to

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the minus absolute value of x.

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So what numbers is this true
for, that the number is equal

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to the minus absolute value?

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It's definitely not true for
positive numbers, right?

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Put a positive 1 there.

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1 is not equal to-- the absolute
value of 1 is 1, so 1

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is not equal to negative 1.

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This works for 0, right?

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0 is equal to negative
0 is equal to 0.

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And this works for
negative numbers.

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Try it out.

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Negative 1 is equal to the
negative absolute value of

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negative 1.

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Well, the absolute value of
negative 1 is 1, so you get

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negative 1 is equal
to negative 1.

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So it works for 0 and
negative numbers.

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So all this tells us-- and maybe
this will help us in

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conjunction with the second
part, who knows?

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This tells us that x is less
than or equal to 0.

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It's just a convoluted
way of saying this.

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Let's see where that gets us.

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Now the second statement.

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Let's see, they say that x
squared is equal to 4.

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Well, this tells us that x is
equal to plus or minus 2.

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Now, if we were trying to figure
out what x is equal to,

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we would actually need both of
these statements because this

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statement says that x is
positive you 2 or negative 2.

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And then this statement
says that, oh, x

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is definitely negative.

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So if we were trying to figure
out what the value of x was,

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we would need both of
these statements.

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But notice, they're asking us
what's the value of the

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absolute value of x, right?

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So regardless of whether x is
positive or negative 2, the

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absolute value of either
positive or negative 2 is

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always going to be equal to 2.

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So really, this is
all you need.

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You only need statement two to
figure out this problem.

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And so that is b.

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You only need statement two.

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All right.

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I think I got that one right.

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Let's see.

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Problem number four.

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I'll do it in this
brownish color.

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Problem number four.

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Is r greater than 0.27?

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Very simple question.

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Is r greater than
0.27, they ask?

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OK, statement one tells us that
r is greater than 1/4.

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OK, well, that doesn't really--
r could still be--

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this is 0.25, so r could still
be equal to 0.251, right?

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It could be 0.251, or
it could be 0.3.

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So this really doesn't give
us any information.

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We don't know whether r
is greater than 0.27.

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Let's see what the second
statement tells us.

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The second statement says
r is equal to 3/10.

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Well, that is equal to 0.3,
and that's definitely

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greater than 0.27.

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So this is all we need.

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We just need statement two.

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Statement one was a
little useless.

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So that is-- I always forget
what letters-- that's b.

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We only need statement two.

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All right.

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How am I doing on time?

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Oh, I have time.

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I think I can do a couple more
problems. These go fast,

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because you don't have to
actually do the math.

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Problem number five.

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What is the value of the sum of
a list of n odd integers?

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OK., and they didn't say
consecutive, and they didn't

00:09:14.610 --> 00:09:16.060
say where it starts.

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It's just n odd integers.

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Fair enough.

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OK, one, they tell us
n is equal to 8.

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So if I knew that I was going to
sum eight odd integers, can

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I know the sum?

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Well, no.

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I mean, it could be-- all of
these could be numbers in the

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millions, or they could be
negative, or they could be

00:09:39.410 --> 00:09:40.240
really small numbers.

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So that doesn't help me much.

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Point number two, they say the
square of the integers on the

00:09:45.850 --> 00:09:49.090
list is 64.

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So they're essentially saying
that n squared is equal to 64.

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And since we're talking about
numbers in a list, it can't be

00:09:55.590 --> 00:09:58.620
negative, so n is equal to 8.

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So these are really telling me
the same thing, just this is a

00:10:01.010 --> 00:10:02.290
little bit more convoluted.

00:10:02.290 --> 00:10:03.910
But really, they
don't help out.

00:10:03.910 --> 00:10:07.450
I could have eight numbers in
the billions, or I could have

00:10:07.450 --> 00:10:10.670
eight numbers in the hundreds,
and so obviously, you're going

00:10:10.670 --> 00:10:12.100
to get a different sum.

00:10:12.100 --> 00:10:14.830
I don't think I can figure
this out anyway.

00:10:14.830 --> 00:10:15.820
So that's what?

00:10:15.820 --> 00:10:19.580
That is statement e, that
together they're not

00:10:19.580 --> 00:10:20.390
sufficient.

00:10:20.390 --> 00:10:23.500
So both of these are useless.

00:10:23.500 --> 00:10:27.460
I still don't know the
answer, which is e.

00:10:27.460 --> 00:10:28.220
All right.

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Well, I think I'm out of time.

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I just passed the
10-minute mark.

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I will continue in
the next video.

00:10:32.510 --> 00:10:33.760
See


Banking 16: Why target rates vs. money supply

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Kind: captions
Language: en

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In the last couple of videos,
we've gone over the idea that

00:00:04.160 --> 00:00:08.230
the Federal Reserve manages the
money supply by setting a

00:00:08.230 --> 00:00:09.660
target interest rate.

00:00:09.660 --> 00:00:11.950
And there might have been the
obvious question circling in

00:00:11.950 --> 00:00:15.900
your brain-- why don't they just
manage the money supply

00:00:15.900 --> 00:00:17.620
by instead of setting a target
interest rate, why don't they

00:00:17.620 --> 00:00:19.340
set a target money supply?

00:00:19.340 --> 00:00:27.070
They could say we have a target
M0 of-- I don't know--

00:00:27.070 --> 00:00:30.540
$900 billion and they just-- if
it's at $800 billion now,

00:00:30.540 --> 00:00:34.030
they just print that much-- $100
billion dollars more of

00:00:34.030 --> 00:00:37.250
base money or Federal Reserve
deposits or Federal Reserve

00:00:37.250 --> 00:00:39.455
notes and then the M0 will get
to $900 billion and then

00:00:39.455 --> 00:00:41.760
you'll have the multiplier
effect and more lending will

00:00:41.760 --> 00:00:44.370
take place and then you
will increase the M1.

00:00:44.370 --> 00:00:46.920
So similarly, they could
have a target M1.

00:00:46.920 --> 00:00:51.960
They could say we want the M1,
which is the M0 plus checking

00:00:51.960 --> 00:00:54.070
deposit accounts-- so
essentially, anything that can

00:00:54.070 --> 00:00:55.160
be used for money.

00:00:55.160 --> 00:00:59.310
So actual cash, reserve
deposits, or checking accounts

00:00:59.310 --> 00:01:00.320
can be used for money because
you can write

00:01:00.320 --> 00:01:01.370
checks against them.

00:01:01.370 --> 00:01:03.890
So they can say, we want that
target to be-- I don't know--

00:01:03.890 --> 00:01:06.930
$2 trillion.

00:01:06.930 --> 00:01:10.210
They can say, we're
targeting the M2.

00:01:10.210 --> 00:01:15.240
M2 is the M1 plus savings
accounts and

00:01:15.240 --> 00:01:16.050
money market accounts.

00:01:16.050 --> 00:01:17.060
So they could say,
we're targeting

00:01:17.060 --> 00:01:19.010
that to be $8 trillion.

00:01:19.010 --> 00:01:19.770
And just so you know,
I actually

00:01:19.770 --> 00:01:20.860
looked up these numbers.

00:01:20.860 --> 00:01:23.570
As of at least '05, '06, these
numbers weren't that far off.

00:01:23.570 --> 00:01:25.980
The M0 was more like $800
billion, but just

00:01:25.980 --> 00:01:26.600
so you get an idea.

00:01:26.600 --> 00:01:28.050
These, are real numbers.

00:01:28.050 --> 00:01:30.410
The obvious question is,
why don't they do that?

00:01:30.410 --> 00:01:32.890
Why don't they just grow
the money supply?

00:01:32.890 --> 00:01:36.180
Maybe one thing they could do,
they could say, our goal is

00:01:36.180 --> 00:01:43.070
for M2 to always be--
50% of GDP, right?

00:01:43.070 --> 00:01:46.920
They could say, let's make
it always 50% of GDP.

00:01:46.920 --> 00:01:50.020
So as the economy grows, we just
have to make sure that if

00:01:50.020 --> 00:01:53.360
it falls below 50% of GDP, that
we just have to print a

00:01:53.360 --> 00:01:55.360
little bit more money, then
it'll have a multiplier effect

00:01:55.360 --> 00:01:56.300
and we'll just keep
measuring it.

00:01:56.300 --> 00:01:59.540
If it goes a little bit above,
we'll do some open market

00:01:59.540 --> 00:02:03.780
operations and sell our
treasuries and take reserves

00:02:03.780 --> 00:02:05.310
out of the banking system.

00:02:05.310 --> 00:02:07.150
So that's a completely
legitimate way of thinking

00:02:07.150 --> 00:02:09.350
about it-- and actually, there
are some people who do

00:02:09.350 --> 00:02:10.360
advocate it this way.

00:02:10.360 --> 00:02:14.040
And there is no clear answer to
why they're doing this, but

00:02:14.040 --> 00:02:16.210
I've thought about a little bit
and there's two reasons

00:02:16.210 --> 00:02:18.550
that I can think of why this
might make more sense--

00:02:18.550 --> 00:02:21.120
although there's a part of me--
and maybe in a future

00:02:21.120 --> 00:02:24.320
video, I'll make an argument
for why actually doing

00:02:24.320 --> 00:02:27.970
something like managing the
money supply to 50% of GDP

00:02:27.970 --> 00:02:29.530
might actually make a little
bit more sense.

00:02:29.530 --> 00:02:30.760
But anyway.

00:02:30.760 --> 00:02:35.090
The first reason is kind of one
out of convenience-- that

00:02:35.090 --> 00:02:37.920
the short term interest rate
with which banks lend to each

00:02:37.920 --> 00:02:40.170
other is just easier to measure
than any of these

00:02:40.170 --> 00:02:41.350
money supply things.

00:02:41.350 --> 00:02:46.500
If I'm Ben Bernanke and I want
to know what banks are lending

00:02:46.500 --> 00:02:49.780
to each other at, I could just
sample the market at that

00:02:49.780 --> 00:02:50.480
moment in time.

00:02:50.480 --> 00:02:52.120
I could say, I'm a bank.

00:02:52.120 --> 00:02:53.320
What are you willing
to lend to me at?

00:02:53.320 --> 00:02:54.630
They'll say, 5.2%.

00:02:54.630 --> 00:02:56.080
They're like, oh, that's a
little bit above our target.

00:02:56.080 --> 00:02:57.550
We have to buy more
treasuries.

00:02:57.550 --> 00:02:59.720
So you can get a very real
time notion of where the

00:02:59.720 --> 00:03:01.880
market is minute by minute.

00:03:01.880 --> 00:03:04.090
You don't have to wait for some
surveys to get completed

00:03:04.090 --> 00:03:05.150
or anything like that.

00:03:05.150 --> 00:03:08.350
While if you were targeting
actual money supply you would

00:03:08.350 --> 00:03:11.040
have to tabulate these fairly
quickly if you wanted real

00:03:11.040 --> 00:03:13.450
time information and that would
just be more of a mess.

00:03:13.450 --> 00:03:16.500
To actually calculate the M2,
you'd have to survey the banks

00:03:16.500 --> 00:03:18.880
and maybe you could do it with
some IT systems, but you're

00:03:18.880 --> 00:03:21.060
not going to get that real time
information-- or at least

00:03:21.060 --> 00:03:22.650
it would be harder to.

00:03:22.650 --> 00:03:25.220
The other reason-- and this is
a little bit more abstract,

00:03:25.220 --> 00:03:27.220
but I think it'll make
sense to you.

00:03:27.220 --> 00:03:32.520
Let's say it's the
planting season.

00:03:32.520 --> 00:03:35.290
I've never been a farmer, but I
think the planting season is

00:03:35.290 --> 00:03:36.570
sometime in the spring.

00:03:36.570 --> 00:03:40.320
And let's say there's a couple
of farm projects where farmers

00:03:40.320 --> 00:03:42.110
need to borrow money
to buy seeds.

00:03:42.110 --> 00:03:48.270
One of them returns a-- the
farmer will proceed if he can

00:03:48.270 --> 00:03:51.960
get lending at 20% or lower
interest rates.

00:03:51.960 --> 00:03:54.430
So if someone's willing to lend
him money at 21% interest

00:03:54.430 --> 00:03:56.000
rate, he'll be like, no,
that's way too much.

00:03:56.000 --> 00:03:59.000
But if he can get money at
19%, he's like, OK, I'll

00:03:59.000 --> 00:04:02.030
borrow the money and I'll buy
the seeds because it will

00:04:02.030 --> 00:04:04.420
create so much value that I'll
easily be able to pay back

00:04:04.420 --> 00:04:05.450
that interest.

00:04:05.450 --> 00:04:09.670
Say there's another farmer
with an 18% project.

00:04:09.670 --> 00:04:13.170
So if he gets 18% or lower
interest rates, he'll proceed

00:04:13.170 --> 00:04:14.610
with his project.

00:04:14.610 --> 00:04:19.380
Let's say there's another farmer
with a-- let's say it's

00:04:19.380 --> 00:04:22.270
a 12%-- project.

00:04:22.270 --> 00:04:24.880
If he gets funding at 11%, he'll
move forward and he'll

00:04:24.880 --> 00:04:26.740
buy the seeds and he'll
plant them.

00:04:26.740 --> 00:04:27.650
Let's say there's a
couple of other

00:04:27.650 --> 00:04:28.980
projects in this universe.

00:04:28.980 --> 00:04:31.370
Let's say there's
a factory guy.

00:04:31.370 --> 00:04:33.710
He's got a really good idea, a
new technology he wants to

00:04:33.710 --> 00:04:36.000
invest in and he's going to
move forward building the

00:04:36.000 --> 00:04:43.050
factory if he can get-- I don't
know-- 19% funding.

00:04:43.050 --> 00:04:47.260
And let's say there's another
factory guy who

00:04:47.260 --> 00:04:53.360
would get 3% funding.

00:04:53.360 --> 00:04:55.730
So he's not too confident
about his project.

00:04:55.730 --> 00:04:58.680
He thinks this project only
makes sense to move forward if

00:04:58.680 --> 00:05:00.650
he can get 3% or
better funding.

00:05:00.650 --> 00:05:03.290
So when I say better,
less than 3%.

00:05:03.290 --> 00:05:04.630
My phone is ringing,
but I'll ignore it

00:05:04.630 --> 00:05:05.470
because I'm on a roll.

00:05:05.470 --> 00:05:08.170
And there's another guy who's
really marginal, really shady.

00:05:08.170 --> 00:05:09.650
He's got a really
shady project.

00:05:09.650 --> 00:05:11.790
He himself is not too
confident in it.

00:05:11.790 --> 00:05:15.140
He will only proceed with this
project if he essentially gets

00:05:15.140 --> 00:05:16.300
money for free.

00:05:16.300 --> 00:05:18.585
So this is the state of affairs
in in the spring or

00:05:18.585 --> 00:05:21.140
during the planting season.

00:05:21.140 --> 00:05:23.740
So all of these would be
potential consumers of money.

00:05:23.740 --> 00:05:25.280
And let's say that this
is the money supply.

00:05:25.280 --> 00:05:28.590
Let's say the money supply is
fixed at that moment in time.

00:05:28.590 --> 00:05:32.550
So let's say-- I'll draw the
money supply circles so

00:05:32.550 --> 00:05:38.390
there's three circles
of money, right?

00:05:38.390 --> 00:05:41.420
So essentially the money is
going to be lent to the people

00:05:41.420 --> 00:05:43.590
willing to pay the highest
interest rate.

00:05:43.590 --> 00:05:46.590
So in this case-- for the sake
of simplicity, we're assuming

00:05:46.590 --> 00:05:49.320
all these are kind of the same
amount of money, just not to

00:05:49.320 --> 00:05:50.910
make things too complicated.

00:05:50.910 --> 00:05:53.260
So in a capitalist system,
the three best projects

00:05:53.260 --> 00:05:54.560
would get the money.

00:05:54.560 --> 00:05:58.490
And so it'll be this one, this
one, and this one, right?

00:05:58.490 --> 00:06:01.380
These three guys will
get the money.

00:06:01.380 --> 00:06:06.520
And essentially they're going
to pay the highest interest

00:06:06.520 --> 00:06:08.790
rate that the worst among
them is willing to pay.

00:06:08.790 --> 00:06:11.330
So this money is going to go
to these three guys at

00:06:11.330 --> 00:06:24.080
essentially 17.9%, right?

00:06:24.080 --> 00:06:25.780
I'm making a lot of simplifying
assumptions, but I

00:06:25.780 --> 00:06:27.710
really just want you to get
the underlying idea.

00:06:27.710 --> 00:06:30.170
And these projects, these three
products are not going

00:06:30.170 --> 00:06:31.380
to get done.

00:06:31.380 --> 00:06:33.830
And you might say, well, it's
good that society didn't

00:06:33.830 --> 00:06:35.650
allocate money to this guy and
this guy because these were

00:06:35.650 --> 00:06:38.350
shady projects to begin with,
but it's kind of unfortunate.

00:06:38.350 --> 00:06:42.460
This was a 12% yield project
that if somehow the capital

00:06:42.460 --> 00:06:45.350
was there, we would've gotten a
12% return on society, which

00:06:45.350 --> 00:06:47.600
is-- in the big picture of
things, a really good project,

00:06:47.600 --> 00:06:49.510
but there just wasn't
enough capital at

00:06:49.510 --> 00:06:50.290
that moment in time.

00:06:50.290 --> 00:06:53.250
There wasn't enough money at
that moment in time to support

00:06:53.250 --> 00:06:54.260
this project.

00:06:54.260 --> 00:06:55.270
Fair enough.

00:06:55.270 --> 00:06:58.170
But let's say the money supply
stays constant-- or at least

00:06:58.170 --> 00:07:01.150
in the medium term over the
course of a year because

00:07:01.150 --> 00:07:03.000
that's what the Fed
is targeting.

00:07:03.000 --> 00:07:07.500
So as we get away from the
planting season, these

00:07:07.500 --> 00:07:08.750
projects disappear.

00:07:12.950 --> 00:07:14.550
They're no longer there because
the planting season

00:07:14.550 --> 00:07:15.650
isn't there anymore.

00:07:15.650 --> 00:07:17.500
And let's say this guy got done,
but let's say there's

00:07:17.500 --> 00:07:21.480
another project just
like it that's 19%.

00:07:21.480 --> 00:07:23.796
And all of a sudden, since the
planting season's done, none

00:07:23.796 --> 00:07:26.370
of the farmers want money
anymore, but if you're keeping

00:07:26.370 --> 00:07:28.760
the money supply constant,
now which projects are

00:07:28.760 --> 00:07:29.170
going to get done?

00:07:29.170 --> 00:07:32.580
Well, this good project here is
going to get done, but so

00:07:32.580 --> 00:07:34.870
are these two kind of
crappy projects.

00:07:34.870 --> 00:07:37.630
And they're going to be lent
at a much lower rate.

00:07:37.630 --> 00:07:39.400
The average rate that it gets
lent to is going to be 1% or

00:07:39.400 --> 00:07:41.380
2% or something really low.

00:07:41.380 --> 00:07:44.790
So you have a situation here
where the money supply did

00:07:44.790 --> 00:07:48.050
not-- it wasn't elastic with
the demand and the negative

00:07:48.050 --> 00:07:51.380
side effect to society in this
situation is, when people

00:07:51.380 --> 00:07:56.040
needed money, we were passing
on good projects that really

00:07:56.040 --> 00:07:57.330
should have been done
because these

00:07:57.330 --> 00:07:58.970
were really safe projects.

00:07:58.970 --> 00:08:01.910
And then later, when the timing
is bad and we keep the

00:08:01.910 --> 00:08:05.230
money supply constant, bad
projects will get funded

00:08:05.230 --> 00:08:07.590
because there's just so much
money to go around and none of

00:08:07.590 --> 00:08:09.980
these people need to use it
that these really crappy

00:08:09.980 --> 00:08:12.460
projects that might even be
negative-- remember, these are

00:08:12.460 --> 00:08:14.190
what the investor thinks they're
going to get, but

00:08:14.190 --> 00:08:16.440
maybe there's a lot of risk
and these end up-- if the

00:08:16.440 --> 00:08:18.910
investor thinks they're going to
get a 1% return, maybe they

00:08:18.910 --> 00:08:19.580
made a mistake.

00:08:19.580 --> 00:08:21.880
Maybe they'll get a -5% return,
in which case we're

00:08:21.880 --> 00:08:23.610
going to be destroying wealth.

00:08:23.610 --> 00:08:26.610
So this is the problem where
over a medium period of time,

00:08:26.610 --> 00:08:31.600
if you hold the money supply
constant, you'll be passing up

00:08:31.600 --> 00:08:36.200
on good projects when there's
a lot of demand for them.

00:08:36.200 --> 00:08:39.250
And then you'll be investing in
bad projects when there's

00:08:39.250 --> 00:08:40.960
not much demand for projects.

00:08:40.960 --> 00:08:42.710
On the other hand, if you
had-- let's do the same

00:08:42.710 --> 00:08:44.670
scenario over again.

00:08:44.670 --> 00:08:47.100
I think I made that a little
messy Let's say you have a

00:08:47.100 --> 00:08:48.570
couple farmers again.

00:08:48.570 --> 00:08:50.530
Let me draw a line here.

00:08:50.530 --> 00:08:59.120
So you have that 20%, 18%, 12%,
and then you have the

00:08:59.120 --> 00:09:04.780
19%, 3%, and 1%.

00:09:04.780 --> 00:09:09.080
Now, if you were managing the
money supply to an interest

00:09:09.080 --> 00:09:11.530
rate-- and remember, the
interest rate-- the federal

00:09:11.530 --> 00:09:13.870
funds rate, is the rate
that banks lend

00:09:13.870 --> 00:09:15.460
to each other, right?

00:09:15.460 --> 00:09:19.230
But as we saw, when you inject
reserves into the banking

00:09:19.230 --> 00:09:22.370
system, it lowers the rate that
reserves are lent to each

00:09:22.370 --> 00:09:25.560
other, but also increases the
lending capacity of banks.

00:09:25.560 --> 00:09:27.460
So it increases the
money supply.

00:09:27.460 --> 00:09:30.430
And so when you increase the
money supply overall the

00:09:30.430 --> 00:09:33.570
lending capacity, you're also
lowering the rate at which

00:09:33.570 --> 00:09:35.430
banks lend to projects, right?

00:09:35.430 --> 00:09:36.650
You're increasing the
amount of money.

00:09:36.650 --> 00:09:38.850
Maybe the projects haven't
changed that much.

00:09:38.850 --> 00:09:42.330
So more money chasing the same
number of projects-- the cost

00:09:42.330 --> 00:09:45.450
of lending is going
to go down, right?

00:09:45.450 --> 00:09:48.220
So let's say the Fed manages
the interest rate in such a

00:09:48.220 --> 00:09:51.530
way that the Fed target rate
was 5%, but let's say that

00:09:51.530 --> 00:09:54.340
turns into bank lending to
real projects at-- I

00:09:54.340 --> 00:09:55.590
don't know-- 8%.

00:10:00.980 --> 00:10:03.100
So in this case, we're not
fixing the money supply.

00:10:03.100 --> 00:10:06.140
We're just adjusting the money
supply in such a way that the

00:10:06.140 --> 00:10:07.650
interest rate is fixed.

00:10:07.650 --> 00:10:09.670
So now during the planting
season, which products are

00:10:09.670 --> 00:10:10.830
going to get funded?

00:10:10.830 --> 00:10:13.750
This one, this one, this
one, and this one.

00:10:13.750 --> 00:10:15.720
These guys are not going
to get funded.

00:10:15.720 --> 00:10:18.480
And then once the planting
season is over, we're still

00:10:18.480 --> 00:10:19.550
keeping the interest
rate the same.

00:10:19.550 --> 00:10:21.510
Maybe we'll contract the money
supply in order to keep

00:10:21.510 --> 00:10:23.360
interest rate-- and of course,
this isn't what

00:10:23.360 --> 00:10:23.920
they manage it to.

00:10:23.920 --> 00:10:25.550
They manage it to the inter-bank
lending, but it's

00:10:25.550 --> 00:10:26.170
all related.

00:10:26.170 --> 00:10:27.810
I just want to give you a sense
of why it makes more

00:10:27.810 --> 00:10:29.660
sense to manage to
an interest rate.

00:10:29.660 --> 00:10:32.090
So once the planting season
is over and some of these

00:10:32.090 --> 00:10:35.540
projects aren't really available
as projects-- these

00:10:35.540 --> 00:10:39.540
were all the planting projects--
in this situation

00:10:39.540 --> 00:10:42.830
when we had a constant money
supply, we would lend to these

00:10:42.830 --> 00:10:45.790
crappy projects, but now that
we keep the interest rates

00:10:45.790 --> 00:10:49.850
constant or relatively fixed,
still only the good project is

00:10:49.850 --> 00:10:53.160
going to get funded and we
don't have to worry about

00:10:53.160 --> 00:10:55.320
banks just because they're
chasing yield and they're so

00:10:55.320 --> 00:10:59.400
flush with cash that they're
chasing bad projects.

00:10:59.400 --> 00:11:01.720
So that's the underlying
rationale, at least from my

00:11:01.720 --> 00:11:03.930
point of view, why it makes
sense to manage to an interest

00:11:03.930 --> 00:11:05.800
rate as opposed to
a money supply.

00:11:05.800 --> 00:11:10.650
It allows the money supply to
expand and contract naturally

00:11:10.650 --> 00:11:13.370
in real time according to
market demands for cash.

00:11:13.370 --> 00:11:15.190
And by setting the interest
rates, you're essentially

00:11:15.190 --> 00:11:19.000
setting the threshold over which
you're willing to let

00:11:19.000 --> 00:11:23.510
projects only that meet that
threshold get funded-- and not

00:11:23.510 --> 00:11:25.870
products below it that might
somehow waste money.

00:11:25.870 --> 00:11:27.820
Anyway, we'll discuss this a lot
more in a lot of different

00:11:27.820 --> 00:11:29.330
videos and hit it from different
angles, but I just

00:11:29.330 --> 00:11:31.580
wanted to answer those
questions, just so you know

00:11:31.580 --> 00:11:33.560
this wasn't some convoluted
crazy thing that they're

00:11:33.560 --> 00:11:34.930
doing, although it is a
little bit convoluted.

00:11:34.930 --> 00:11:36.410
It's just not that crazy.

00:11:36.410 --> 00:11:38.720
Anyway, see you in
the next video.


Banking 15: More on the Fed Funds Rate

WEBVTT
Kind: captions
Language: en

00:00:00.770 --> 00:00:03.440
Let's a review a little bit
of what we've gone over.

00:00:03.440 --> 00:00:05.880
And I think it helps to see the
whole process again, just

00:00:05.880 --> 00:00:09.140
so it really sinks into your
brain and I've drawn the banks

00:00:09.140 --> 00:00:10.770
in a different arrangement
this time.

00:00:10.770 --> 00:00:12.880
But just as a review, this
is a bank with a

00:00:12.880 --> 00:00:14.070
little bit less reserves.

00:00:14.070 --> 00:00:15.930
The green right here
is their reserves.

00:00:15.930 --> 00:00:19.590
It could either be deposits at
the federal reserve or these

00:00:19.590 --> 00:00:21.660
could actually be federal
reserve notes-- and we all

00:00:21.660 --> 00:00:23.810
know that as dollars or cash.

00:00:23.810 --> 00:00:27.000
This is another bank with
slightly more reserves.

00:00:27.000 --> 00:00:28.920
And just like I said in the last
video, I'm drawing the

00:00:28.920 --> 00:00:31.740
reserves at the top of the asset
side now so that we can

00:00:31.740 --> 00:00:34.760
compare it directly with the
demand deposits or the

00:00:34.760 --> 00:00:35.900
liabilities of this bank.

00:00:35.900 --> 00:00:37.850
Most banks have other
liabilities, but I've just

00:00:37.850 --> 00:00:39.690
assumed that all of them
are demand deposit.

00:00:39.690 --> 00:00:42.020
That's this magenta
square here.

00:00:42.020 --> 00:00:45.440
And of course their equity
is the blue right there.

00:00:45.440 --> 00:00:47.780
Let me make sure I have it.

00:00:47.780 --> 00:00:50.290
That's their equity.

00:00:50.290 --> 00:00:53.900
And of course if these are
either federal reserve notes

00:00:53.900 --> 00:00:57.880
or these are deposits within the
reserve bank, those are of

00:00:57.880 --> 00:01:00.880
course liabilities for the
reserve bank itself.

00:01:00.880 --> 00:01:04.099
So let me draw a line
from there to there.

00:01:04.099 --> 00:01:08.430
This is a liability for
the reserve bank.

00:01:08.430 --> 00:01:12.230
If these were deposits, if these
were essentially demand

00:01:12.230 --> 00:01:14.680
accounts with the reserve
bank, then we could even

00:01:14.680 --> 00:01:16.790
divide them up a little bit and
separate-- OK, this guy

00:01:16.790 --> 00:01:19.840
has this much-- I don't know
if you can see that.

00:01:19.840 --> 00:01:22.640
That color's not so good.

00:01:22.640 --> 00:01:23.700
This guy has this much.

00:01:23.700 --> 00:01:25.620
This guy has this much, but if
these are all federal reserve

00:01:25.620 --> 00:01:28.930
notes, they kind of all come
out of the same bucket.

00:01:28.930 --> 00:01:34.090
What we learned in the last
video is that the federal

00:01:34.090 --> 00:01:36.720
reserve-- they don't say,
we want the money

00:01:36.720 --> 00:01:39.630
supply to be X or Y.

00:01:39.630 --> 00:01:43.140
They always talk about in
terms of interest rates.

00:01:43.140 --> 00:01:46.160
They always say, our target
interest rate or the federal

00:01:46.160 --> 00:01:49.005
reserve rate is now
going to be X.

00:01:49.005 --> 00:01:52.650
Let's go over our mechanics a
little bit more on how open

00:01:52.650 --> 00:01:55.900
market transactions help to
make those rates happen.

00:01:55.900 --> 00:02:00.100
So let's say that on day one
or before the fed does

00:02:00.100 --> 00:02:03.000
anything, this bank has a little
bit extra reserves,

00:02:03.000 --> 00:02:05.300
this bank has a little
bit less reserves.

00:02:05.300 --> 00:02:06.980
So there's a couple things that
this bank could do with

00:02:06.980 --> 00:02:08.320
these extra reserves.

00:02:08.320 --> 00:02:12.400
It could either do some more
lending-- so it could

00:02:12.400 --> 00:02:19.440
actually-- because it's
reserve-- let's say it's at a

00:02:19.440 --> 00:02:22.180
20% reserve ratio.

00:02:22.180 --> 00:02:24.460
This ratio to this is 20%.

00:02:24.460 --> 00:02:27.670
And it can be as low as-- it
would feel comfortable being

00:02:27.670 --> 00:02:29.060
at a 15% reserve ratio.

00:02:29.060 --> 00:02:32.330
So roughly a fourth of its
reserves could be used for

00:02:32.330 --> 00:02:33.260
doing something else.

00:02:33.260 --> 00:02:34.470
And what could it be used for?

00:02:34.470 --> 00:02:37.180
So let's say this portion of its
reserves could be used for

00:02:37.180 --> 00:02:38.260
something else.

00:02:38.260 --> 00:02:39.920
Well, it could lend them
to another bank

00:02:39.920 --> 00:02:41.220
who maybe needs reserves.

00:02:41.220 --> 00:02:43.820
So that could be this
right here.

00:02:43.820 --> 00:02:45.980
This bank maybe wants some
reserves and then it would add

00:02:45.980 --> 00:02:47.130
it up on here.

00:02:47.130 --> 00:02:50.250
The last video, I filled in the
reserves down here, but

00:02:50.250 --> 00:02:52.470
actually they're not replacing
other assets.

00:02:52.470 --> 00:02:54.130
They would have actually just
been added to the balance

00:02:54.130 --> 00:02:54.570
sheet of the bank.

00:02:54.570 --> 00:02:56.960
So I should have drawn them on
top and I'll do that a second.

00:02:56.960 --> 00:02:58.880
But the other option that this
bank could do is that they

00:02:58.880 --> 00:03:01.720
could actually do
more lending.

00:03:01.720 --> 00:03:03.860
Since the reserve ratio is
higher than they want, they

00:03:03.860 --> 00:03:05.860
can actually create checking
accounts like we saw on the

00:03:05.860 --> 00:03:07.610
last couple of videos.

00:03:07.610 --> 00:03:10.810
With that said, let's say that
this guy wants to borrow some.

00:03:10.810 --> 00:03:12.620
This guy's willing to lend some,
although that's not his

00:03:12.620 --> 00:03:15.010
only alternative.

00:03:15.010 --> 00:03:16.830
He could create checking
accounts essentially with it

00:03:16.830 --> 00:03:18.190
and do some more lending
with it.

00:03:18.190 --> 00:03:20.600
And let's say in this reality
right now given how much

00:03:20.600 --> 00:03:23.100
reserves are on the banking
system at the current rate--

00:03:23.100 --> 00:03:27.650
let me write that right here.

00:03:27.650 --> 00:03:33.510
The current rate is 6%.

00:03:33.510 --> 00:03:36.015
Now the federal reserve
says, you know what?

00:03:36.015 --> 00:03:37.680
I would like to expand
the money supply.

00:03:37.680 --> 00:03:38.920
And they don't say
it directly.

00:03:38.920 --> 00:03:40.740
They don't tell us in
our newspapers.

00:03:40.740 --> 00:03:42.450
They don't make a press release
saying, we would like

00:03:42.450 --> 00:03:46.210
the official M1 value of the
money supply to go from $15

00:03:46.210 --> 00:03:47.870
trillion to $20 trillion.

00:03:47.870 --> 00:03:48.990
They don't say that.

00:03:48.990 --> 00:03:51.920
They say, we are going
to lower the federal

00:03:51.920 --> 00:03:53.850
funds rate to 5%.

00:03:53.850 --> 00:04:03.350
So let's say they want a federal
funds rate-- they are

00:04:03.350 --> 00:04:05.010
setting to be 5%.

00:04:05.010 --> 00:04:08.370
The governors of the federal
reserve bank sit together and

00:04:08.370 --> 00:04:10.680
Bernanke comes out and says,
we're lowering the federal

00:04:10.680 --> 00:04:12.440
funds rate to 5%.

00:04:12.440 --> 00:04:15.310
So what that 5% percent
means is that their

00:04:15.310 --> 00:04:17.240
target rate is now 5%.

00:04:17.240 --> 00:04:18.490
So this is a target.

00:04:21.810 --> 00:04:24.940
So what they're saying is, we
are going to perform open

00:04:24.940 --> 00:04:28.760
market transactions in such a
way that now when this bank

00:04:28.760 --> 00:04:32.040
offers money to this bank it's
going to reduce its rate from

00:04:32.040 --> 00:04:35.550
6% to 5%-- or another way to
put it, they're going to do

00:04:35.550 --> 00:04:39.730
open market transactions or
operations in such a way that

00:04:39.730 --> 00:04:43.210
the demand might also go down
for the reserves so this guy

00:04:43.210 --> 00:04:46.680
might be willing to pay less for
borrowing from this guy;

00:04:46.680 --> 00:04:48.260
instead of being willing
to pay 6%, he'll be

00:04:48.260 --> 00:04:49.660
willing to pay 5%.

00:04:49.660 --> 00:04:53.180
Remember, on any transaction,
both people

00:04:53.180 --> 00:04:54.180
have to agree on it.

00:04:54.180 --> 00:04:55.140
So how do they do that?

00:04:55.140 --> 00:04:57.370
And I think we've we're
reasonably familiar with the

00:04:57.370 --> 00:04:59.050
mechanics now.

00:04:59.050 --> 00:05:00.980
So what the federal reserve
could do is they can print

00:05:00.980 --> 00:05:02.230
some notes.

00:05:05.230 --> 00:05:06.620
Those are assets because
they haven't done

00:05:06.620 --> 00:05:07.870
anything with them yet.

00:05:10.340 --> 00:05:11.990
And then there's a corresponding
liability.

00:05:11.990 --> 00:05:14.040
I'll do that in a slightly
different shade of green.

00:05:16.665 --> 00:05:19.780
These are notes outstanding,
right?

00:05:19.780 --> 00:05:22.120
See, I should've done all this
in this darker shade of green.

00:05:22.120 --> 00:05:23.570
These are the liabilities.

00:05:23.570 --> 00:05:26.290
The light green are the assets,
the notes themselves.

00:05:26.290 --> 00:05:29.720
And what the federal reserve
does-- because they don't want

00:05:29.720 --> 00:05:30.850
to become an insolvent bank.

00:05:30.850 --> 00:05:33.960
They want to buy the most
liquid, safest assets out

00:05:33.960 --> 00:05:36.080
there and it actually makes a
lot of sense and we'll touch

00:05:36.080 --> 00:05:37.820
on this in a lot of
different ways.

00:05:37.820 --> 00:05:40.875
What they say is, we're going to
take this money and inject

00:05:40.875 --> 00:05:44.820
it into the system by buying
treasuries with it.

00:05:44.820 --> 00:05:46.640
And they could be buying those
treasuries from your

00:05:46.640 --> 00:05:49.040
grandmother, they could be
buying it from China, they

00:05:49.040 --> 00:05:50.890
could be buying it from Russia,
they could be buying

00:05:50.890 --> 00:05:54.030
it from me, they could be
buying it from my uncle.

00:05:54.030 --> 00:05:56.280
Regardless of who they buy it
from-- let's say they buy it

00:05:56.280 --> 00:05:57.820
from someone in the U.S.
so that we don't get

00:05:57.820 --> 00:05:59.160
confused right now.

00:05:59.160 --> 00:06:01.380
Let's say they buy
it from my uncle.

00:06:01.380 --> 00:06:03.940
So this is my uncle.

00:06:03.940 --> 00:06:05.230
Let me see if I can draw him.

00:06:07.900 --> 00:06:11.740
He's holding a treasury right
now-- an IOU from the

00:06:11.740 --> 00:06:12.790
government.

00:06:12.790 --> 00:06:13.870
That's what he has.

00:06:13.870 --> 00:06:17.620
He wasn't willing to sell it
before, but let's say the

00:06:17.620 --> 00:06:21.850
federal reserve has printed
more money and he's like,

00:06:21.850 --> 00:06:23.840
well, I'm not going to sell it
now, but if someone's willing

00:06:23.840 --> 00:06:26.160
to offer me a little bit more
money for it, maybe I'm

00:06:26.160 --> 00:06:30.050
willing to part with
my treasury bill.

00:06:30.050 --> 00:06:32.130
So the federal reserve-- and
he doesn't know that he's

00:06:32.130 --> 00:06:33.150
selling it to the
federal reserve.

00:06:33.150 --> 00:06:35.600
He just sees selling it to
market, the same way that when

00:06:35.600 --> 00:06:38.380
you buy a stock, you don't know
who you're buying it from

00:06:38.380 --> 00:06:40.400
or who you're selling
it to and all that.

00:06:40.400 --> 00:06:42.660
So all of a sudden someone goes
out there and is willing

00:06:42.660 --> 00:06:45.380
to pay a slightly higher price
for these treasury bills,

00:06:45.380 --> 00:06:48.130
these IOUs from the government
and he's like, oh, fine.

00:06:48.130 --> 00:06:49.280
Yeah, that's a good price.

00:06:49.280 --> 00:06:51.850
I'm going to sell them to
whoever's buying it.

00:06:51.850 --> 00:06:53.390
It turns out that it's actually
the federal reserve

00:06:53.390 --> 00:06:54.410
that's buying it.

00:06:54.410 --> 00:06:59.430
So the federal reserve all of a
sudden has-- my uncle would

00:06:59.430 --> 00:07:01.270
be a big time operator if
the federal reserve

00:07:01.270 --> 00:07:03.930
only bought from him.

00:07:03.930 --> 00:07:06.700
He would have to have hundreds
of billions of dollars of

00:07:06.700 --> 00:07:07.710
these things.

00:07:07.710 --> 00:07:09.810
And he doesn't have
his IOU anymore.

00:07:09.810 --> 00:07:11.530
What does he have right now?

00:07:11.530 --> 00:07:17.010
That IOU is now exchanged for
a dollar bill or hundreds of

00:07:17.010 --> 00:07:20.940
billions of dollar bills or
reserve deposits at the

00:07:20.940 --> 00:07:23.910
federal reserve-- all the same,
but just to keep the

00:07:23.910 --> 00:07:27.280
abstraction solid for right now,
we'll keep it in terms of

00:07:27.280 --> 00:07:27.780
dollar bills.

00:07:27.780 --> 00:07:30.300
So his IOUs he's sold
in exchange for

00:07:30.300 --> 00:07:30.870
these dollar bills.

00:07:30.870 --> 00:07:32.150
And what does he do with them?

00:07:32.150 --> 00:07:33.490
This is hundreds of billions
of dollars.

00:07:33.490 --> 00:07:35.150
He's not going to stuff it
all into his mattress.

00:07:35.150 --> 00:07:38.050
He's going to deposit it into
the banking system.

00:07:38.050 --> 00:07:41.830
So maybe he gives a little
bit to this bank up here.

00:07:41.830 --> 00:07:44.310
This is a slight mistake that
I did in the last video.

00:07:44.310 --> 00:07:46.060
I was adding it below,
but it's not

00:07:46.060 --> 00:07:46.700
replacing other assets.

00:07:46.700 --> 00:07:48.460
It's new assets.

00:07:48.460 --> 00:07:52.230
So let's say he put some of it
here-- my uncle after he sold

00:07:52.230 --> 00:07:54.080
his treasuries.

00:07:54.080 --> 00:07:56.060
Let's say he put some of it in
this bank-- or maybe it's a

00:07:56.060 --> 00:07:57.400
bunch of people's uncles
and they all don't

00:07:57.400 --> 00:07:58.720
go to the same bank.

00:07:58.720 --> 00:08:00.900
Let me do that in a slightly
different shade of green, just

00:08:00.900 --> 00:08:03.370
so you know this is--
I'll do in blue.

00:08:03.370 --> 00:08:06.150
Just so you know, this is a new
deposit, but it's close

00:08:06.150 --> 00:08:09.560
enough to green that I think
you get the idea.

00:08:09.560 --> 00:08:12.980
And of course, he has an off
setting-- his checking account

00:08:12.980 --> 00:08:14.390
if he didn't have one already.

00:08:14.390 --> 00:08:16.150
Now he has one so their
liabilities

00:08:16.150 --> 00:08:17.400
increase a little bit.

00:08:21.260 --> 00:08:22.620
So a couple of things
will happen.

00:08:22.620 --> 00:08:25.160
Just in terms of how does this
affect the rate that they're

00:08:25.160 --> 00:08:26.060
charging to each other?

00:08:26.060 --> 00:08:28.570
Well, now all of a sudden, this
bank's reserve ratio's

00:08:28.570 --> 00:08:29.560
gotten a little bit better.

00:08:29.560 --> 00:08:32.929
His assets and his liabilities
increased, right?

00:08:32.929 --> 00:08:36.400
His assets increased by the
amount of my uncle's deposit,

00:08:36.400 --> 00:08:37.460
but so did the liabilities
because he's

00:08:37.460 --> 00:08:38.690
had the demand deposit.

00:08:38.690 --> 00:08:42.090
But it came in a ratio
of reserves to

00:08:42.090 --> 00:08:43.490
demand deposit 100%.

00:08:43.490 --> 00:08:46.050
So this would have improved
his reserve ratio.

00:08:46.050 --> 00:08:51.760
If you now take the ratio of
this height to this height,

00:08:51.760 --> 00:08:54.220
it's not going to improve
a little bit, right?

00:08:54.220 --> 00:08:57.480
So now he doesn't need money--
this bank doesn't need money

00:08:57.480 --> 00:09:00.030
as bad in order to improve
its reserve ratio.

00:09:00.030 --> 00:09:02.850
And likewise, this bank now
even has an even better

00:09:02.850 --> 00:09:03.460
reserve ratio.

00:09:03.460 --> 00:09:05.520
He already had more reserves
than he needed and

00:09:05.520 --> 00:09:06.570
now he got even more.

00:09:06.570 --> 00:09:08.950
He has an even better
reserve ratio.

00:09:08.950 --> 00:09:12.610
So now this guy's demand for
reserves is a little bit lower

00:09:12.610 --> 00:09:14.400
and this guy's supply
of reserves is

00:09:14.400 --> 00:09:15.630
a little bit higher.

00:09:15.630 --> 00:09:18.190
So this guy's only going to be
willing to pay a little bit

00:09:18.190 --> 00:09:21.190
less for new reserves
from this bank.

00:09:21.190 --> 00:09:23.500
And this guy, he's willing
to charge less now

00:09:23.500 --> 00:09:24.300
because he has more.

00:09:24.300 --> 00:09:25.430
He doesn't know what
to do with it.

00:09:25.430 --> 00:09:28.750
He doesn't know enough people
who want to borrow more money

00:09:28.750 --> 00:09:31.060
so he wants actually lend off
some of his reserves.

00:09:31.060 --> 00:09:34.230
So just by increasing the
supply of reserves and

00:09:34.230 --> 00:09:37.210
decreasing the demand of
reserve, the current rate-- if

00:09:37.210 --> 00:09:41.960
the fed does this
appropriately-- will go to 5%.

00:09:41.960 --> 00:09:44.340
And let's say it only went to
5-1/2%, then the fed will keep

00:09:44.340 --> 00:09:46.440
doing this and then
it'll go to 5%.

00:09:46.440 --> 00:09:49.860
If it goes too far, if it goes
to 4-1/2%, maybe the fed will

00:09:49.860 --> 00:09:51.690
reverse the transaction.

00:09:51.690 --> 00:09:56.170
The fed will actually go
out there and sell

00:09:56.170 --> 00:09:57.240
these treasury notes.

00:09:57.240 --> 00:10:01.160
But I also want to make it clear
that the point of this--

00:10:01.160 --> 00:10:03.990
although it does affect the
interest rates and that's what

00:10:03.990 --> 00:10:06.610
the federal reserve always talks
about in terms of their

00:10:06.610 --> 00:10:09.870
target rates-- the net effect
of injecting more reserves

00:10:09.870 --> 00:10:11.750
into the system is it increases
the lending

00:10:11.750 --> 00:10:12.790
power of the bank.

00:10:12.790 --> 00:10:16.300
And if we have, let's say, a
10% reserve ratio, every

00:10:16.300 --> 00:10:22.780
dollar that is injected into
the banking system right

00:10:22.780 --> 00:10:26.800
there, that bank can then
do $10 worth of lending.

00:10:26.800 --> 00:10:29.220
Let's say that bank lent
it all to this bank.

00:10:29.220 --> 00:10:31.700
Let's say he lends all of that--
so now this turns to an

00:10:31.700 --> 00:10:34.490
asset, which is a loan
to this bank.

00:10:34.490 --> 00:10:38.220
So this bank then has--
this isn't a

00:10:38.220 --> 00:10:39.290
demand deposit anymore.

00:10:39.290 --> 00:10:42.250
This is now a loan
from this bank.

00:10:42.250 --> 00:10:44.970
He has more reserves now.

00:10:44.970 --> 00:10:45.880
That's his reserves.

00:10:45.880 --> 00:10:47.360
I shouldn't be doing it
in that purple color.

00:10:47.360 --> 00:10:49.730
I should be sticking to green.

00:10:49.730 --> 00:10:52.330
But the bottom line is, wherever
those reserves are,

00:10:52.330 --> 00:10:55.920
doesn't matter which banks they
sit in, but every dollar

00:10:55.920 --> 00:10:59.700
of that increased reserves
enables $10 of lending, right?

00:10:59.700 --> 00:11:06.570
This bank now can create $10 of
checking accounts through

00:11:06.570 --> 00:11:12.160
lending and so even though the
federal reserve talks in terms

00:11:12.160 --> 00:11:14.160
of interest rates-- and I'll
talk a lot about why they're

00:11:14.160 --> 00:11:16.990
more focused on interest rates
than absolute measures of the

00:11:16.990 --> 00:11:19.510
money supply-- even though they
talk in terms of interest

00:11:19.510 --> 00:11:25.630
rates, by performing these open
market transactions that

00:11:25.630 --> 00:11:28.150
in effect lower the interest
rate by increasing the amount

00:11:28.150 --> 00:11:31.980
of reserves out there, they're
actually increasing banks'

00:11:31.980 --> 00:11:33.130
lending capacity.

00:11:33.130 --> 00:11:36.610
So the amount of reserves--
that's base money-- or you

00:11:36.610 --> 00:11:39.670
could almost view it as the
liability side of the federal

00:11:39.670 --> 00:11:41.420
funds, the reserve deposits.

00:11:41.420 --> 00:11:42.200
That's base money.

00:11:42.200 --> 00:11:43.730
That's M0.

00:11:43.730 --> 00:11:46.450
And you get a multiplier effect
for M1, which is the

00:11:46.450 --> 00:11:48.490
amount of demand deposits
because in this bank it got

00:11:48.490 --> 00:11:50.430
more reserves and then it can
create a bunch of demand

00:11:50.430 --> 00:11:52.320
deposits like we learned
earlier.

00:11:52.320 --> 00:11:54.650
So by saying that they're
lowering the rates, they're

00:11:54.650 --> 00:11:56.320
essentially saying that they're
going to perform open

00:11:56.320 --> 00:11:59.490
market transactions that will
inject reserves into the

00:11:59.490 --> 00:12:02.510
banking system, which will
allow them to keep their

00:12:02.510 --> 00:12:05.460
reserve ratios in line, but
make a lot more loans.

00:12:05.460 --> 00:12:10.380
So significantly increase the M1
and then the other, looser,

00:12:10.380 --> 00:12:12.700
the broader definitions
of money supply.

00:12:12.700 --> 00:12:15.500
I will see you in
the next video.


Banking 14: Fed Funds Rate

WEBVTT
Kind: captions
Language: en

00:00:00.850 --> 00:00:04.460
So far we've talked about how
the Fed can control the money

00:00:04.460 --> 00:00:07.770
supply by performing these open
market transactions where

00:00:07.770 --> 00:00:10.195
they're buying and selling
Treasury securities.

00:00:10.195 --> 00:00:13.480
But you're probably asking,
when I read the newspaper

00:00:13.480 --> 00:00:15.960
headlines about all of this,
I don't hear about the open

00:00:15.960 --> 00:00:18.890
market transactions so much and
I don't hear about them

00:00:18.890 --> 00:00:19.880
buying treasuries so much.

00:00:19.880 --> 00:00:24.030
I always hear them setting the
Federal funds rate, or the

00:00:24.030 --> 00:00:26.980
discount rate, or
the target rate.

00:00:26.980 --> 00:00:29.110
And what do these words mean
and how do these relate to

00:00:29.110 --> 00:00:30.520
open market transactions?

00:00:30.520 --> 00:00:33.260
So that's what we'll try
to go over right now.

00:00:33.260 --> 00:00:35.870
So what we're going to focus
on is the target rate-- and

00:00:35.870 --> 00:00:38.790
then probably in the next video
or in a couple more

00:00:38.790 --> 00:00:41.070
videos, we'll focus more
on the discount rate.

00:00:41.070 --> 00:00:43.190
And they're two different
things, although they're often

00:00:43.190 --> 00:00:47.080
used in conjunction with each
other and they move in tandem,

00:00:47.080 --> 00:00:50.150
but let's focus on the target
rate because this is how the

00:00:50.150 --> 00:00:54.510
Fed, under normal conditions,
normally sets

00:00:54.510 --> 00:00:56.340
its monetary policy.

00:00:56.340 --> 00:00:59.010
So, the target rate.

00:00:59.010 --> 00:01:01.860
So just so you know the
definition, this is the rate

00:01:01.860 --> 00:01:06.640
that the Fed wants banks to lend
reserves to each other on

00:01:06.640 --> 00:01:08.830
a very short term basis--
so, overnight.

00:01:08.830 --> 00:01:09.810
What does that mean?

00:01:09.810 --> 00:01:11.960
So I drew two banks here-- and
I drew a little bit different

00:01:11.960 --> 00:01:12.820
than I normally do.

00:01:12.820 --> 00:01:14.740
The left-hand side
is the assets.

00:01:14.740 --> 00:01:18.860
The red box is the liabilities
and this blue over here, this

00:01:18.860 --> 00:01:19.800
is the equity.

00:01:19.800 --> 00:01:23.960
And the thing that I did
different is, every video so

00:01:23.960 --> 00:01:26.520
far, I've been drawing
the reserves on the

00:01:26.520 --> 00:01:29.220
bottom of the assets.

00:01:29.220 --> 00:01:30.770
And that actually made it a
little confusing when you

00:01:30.770 --> 00:01:34.510
compare the reserves to
the demand deposits.

00:01:34.510 --> 00:01:36.150
I'm assuming all the liabilities
are demand

00:01:36.150 --> 00:01:38.020
deposits-- that they're not
taking other types of loans.

00:01:38.020 --> 00:01:40.610
So these are all checking
accounts, all of this red area

00:01:40.610 --> 00:01:41.780
right here.

00:01:41.780 --> 00:01:44.080
So I actually finally figured
out that it would be easier to

00:01:44.080 --> 00:01:48.480
compare the reserve ratios if
I had it drawn side by side.

00:01:48.480 --> 00:01:50.710
So let's say this bank right
here-- these are its reserves

00:01:50.710 --> 00:01:54.930
in green-- and these could be
actual dollars, this could be

00:01:54.930 --> 00:01:58.130
actual cash that's sitting in
there in their vault, or it

00:01:58.130 --> 00:02:02.710
could be reserve deposits with
the Federal Reserve.

00:02:02.710 --> 00:02:03.810
They're really the same
thing and they

00:02:03.810 --> 00:02:04.750
can go back and forth.

00:02:04.750 --> 00:02:07.440
And I think that's kind of--
you understand that now.

00:02:07.440 --> 00:02:11.510
And just so you understand, this
asset is a liability of

00:02:11.510 --> 00:02:13.390
the Federal Reserve.

00:02:13.390 --> 00:02:15.550
It's roughly that much of it.

00:02:15.550 --> 00:02:17.340
So that's that.

00:02:17.340 --> 00:02:19.100
An asset for the bank, liability
for the Federal

00:02:19.100 --> 00:02:22.000
Reserve-- and this reserve for
this bank is a liability to

00:02:22.000 --> 00:02:23.830
the Federal Reserve.

00:02:23.830 --> 00:02:26.490
And if these were actually
cash-- if this was actually

00:02:26.490 --> 00:02:29.120
dollar bills and this would say,
notes outstanding-- if

00:02:29.120 --> 00:02:32.840
this asset is a demand deposit
account or reserve deposit

00:02:32.840 --> 00:02:34.500
account with the Federal
Reserve, then this would just

00:02:34.500 --> 00:02:38.170
say, reserve account
for bank B.

00:02:38.170 --> 00:02:41.440
With that said, so this bank,
just visually the way I've

00:02:41.440 --> 00:02:43.200
drawn it-- let me just
fill this in.

00:02:43.200 --> 00:02:46.680
I think looks nice when I
color in the squares.

00:02:46.680 --> 00:02:49.820
This bank-- its reserves just
the way I've drawn it are

00:02:49.820 --> 00:02:52.980
clearly-- its reserve ratio is
clearly lower than this bank

00:02:52.980 --> 00:02:54.150
because this is its demand

00:02:54.150 --> 00:02:55.750
deposits, this is its reserves.

00:02:55.750 --> 00:02:58.240
Let's say that this bank has
reserves-- I'm just eyeballing

00:02:58.240 --> 00:03:02.670
it-- looks like about if you
take the ratio of this height

00:03:02.670 --> 00:03:06.486
to this height, it looks like it
has reserves of maybe-- I'm

00:03:06.486 --> 00:03:10.800
just going to say 10%, while
this one looks more like it

00:03:10.800 --> 00:03:15.000
has-- I don't know-- closer
to 20% reserves.

00:03:15.000 --> 00:03:17.840
And now remember, banks-- we
talked about regulations, so

00:03:17.840 --> 00:03:21.090
there is some minimum reserves
that a bank needs to keep.

00:03:21.090 --> 00:03:23.470
And then, of course, even if
there were no regulation, a

00:03:23.470 --> 00:03:27.110
bank would want to keep some
reserves just in case some of

00:03:27.110 --> 00:03:30.520
these demand deposits-- people
want their cash, so you always

00:03:30.520 --> 00:03:33.060
want to keep some reserves, but
you don't want to keep too

00:03:33.060 --> 00:03:33.780
much reserves.

00:03:33.780 --> 00:03:35.210
Because what happens with
too much reserves?

00:03:35.210 --> 00:03:38.440
Reserves-- you don't get any
interest on a reserve account

00:03:38.440 --> 00:03:39.300
or on cash.

00:03:39.300 --> 00:03:42.630
And that's actually how the--
if you were curious how the

00:03:42.630 --> 00:03:47.020
Fed actually supports itself--
well, it gives these banks

00:03:47.020 --> 00:03:49.120
reserve accounts, which are
essentially checking accounts

00:03:49.120 --> 00:03:51.870
at the Fed-- and it gives
them no interest on it.

00:03:51.870 --> 00:03:54.580
It gives them no interest so
it has no interest on the

00:03:54.580 --> 00:03:55.810
right-hand side of their
balance sheets.

00:03:55.810 --> 00:03:58.320
So it pays no interest
on its liabilities.

00:03:58.320 --> 00:04:00.690
And its liabilities are these
things right here.

00:04:00.690 --> 00:04:03.680
It pays no interest on these
things, but it gets interest

00:04:03.680 --> 00:04:04.670
on some of its assets.

00:04:04.670 --> 00:04:07.480
So here I drew a little
bit of gold.

00:04:07.480 --> 00:04:09.620
This yellow part is
gold right here.

00:04:09.620 --> 00:04:11.530
Let me write that-- gold.

00:04:11.530 --> 00:04:16.440
This right here is gold and then
this brown color-- we'll

00:04:16.440 --> 00:04:17.910
assume that these are
treasuries, right?

00:04:17.910 --> 00:04:20.870
So if I have a government
treasury, it gives me some

00:04:20.870 --> 00:04:23.420
interest. So I'm paying no
interest if I'm the Fed.

00:04:23.420 --> 00:04:27.070
I'm paying no interest on these
reserve deposits or on

00:04:27.070 --> 00:04:28.360
these notes outstanding.

00:04:28.360 --> 00:04:32.490
And I get interest
on my assets.

00:04:32.490 --> 00:04:36.630
So that's easy money and it
actually turns out that what

00:04:36.630 --> 00:04:40.720
the Fed does-- and this is why
it's very ambiguous whether

00:04:40.720 --> 00:04:43.170
it's really independent of
the government or not.

00:04:43.170 --> 00:04:45.260
It is officially a private
institution, but it's a board

00:04:45.260 --> 00:04:48.570
of directors that's appointed
by the government and even

00:04:48.570 --> 00:04:51.440
more, this money that it makes,
any surplus money that

00:04:51.440 --> 00:04:54.690
it has after paying all of the
expenses of the Federal

00:04:54.690 --> 00:04:57.240
Reserve, it actually goes
back to Congress.

00:04:57.240 --> 00:04:59.980
So don't think that somehow
there's this private bank with

00:04:59.980 --> 00:05:02.560
this great money making scheme
because all the money goes

00:05:02.560 --> 00:05:03.250
back to Congress.

00:05:03.250 --> 00:05:04.250
Although that goes both ways.

00:05:04.250 --> 00:05:06.410
If for whatever reason, the Fed
were to do really stupid

00:05:06.410 --> 00:05:09.650
things and it were to become
insolvent, Congress is

00:05:09.650 --> 00:05:13.900
obligated-- we learned before
that these treasury notes are

00:05:13.900 --> 00:05:15.550
obligations of the
U.S. government.

00:05:15.550 --> 00:05:16.500
So it goes both ways.

00:05:16.500 --> 00:05:20.730
So even though it's officially
independent, it really isn't.

00:05:20.730 --> 00:05:24.760
It really is almost a part of
Congress-- or at least a part

00:05:24.760 --> 00:05:27.220
of the government.

00:05:27.220 --> 00:05:29.770
But with that said-- actually,
I should say part of the

00:05:29.770 --> 00:05:32.090
Treasury, not so much
part of Congress.

00:05:32.090 --> 00:05:34.040
I don't want to be technically
incorrect.

00:05:34.040 --> 00:05:36.250
But with that said, let's go
back to this example with

00:05:36.250 --> 00:05:37.300
these two banks.

00:05:37.300 --> 00:05:40.380
So this guy, he probably has
more reserves than he needs.

00:05:40.380 --> 00:05:42.500
And he doesn't like having too
much reserves because you

00:05:42.500 --> 00:05:43.500
don't get any interest on it.

00:05:43.500 --> 00:05:46.940
Let's say that this guy--
he wants 15% reserves.

00:05:46.940 --> 00:05:50.220
He figures that that's more
than enough that he needs.

00:05:50.220 --> 00:05:52.935
And this guy, he feels like he's
getting a little bit low

00:05:52.935 --> 00:05:53.620
on reserves.

00:05:53.620 --> 00:05:56.010
He would also like
to get to 15%.

00:05:56.010 --> 00:05:58.610
So this guy would like to
borrow this much money.

00:06:01.160 --> 00:06:04.270
Reserves would actually be
physical cash or reserve

00:06:04.270 --> 00:06:05.570
deposits with the Fed.

00:06:05.570 --> 00:06:11.310
And this guy, he has about
this much to lend.

00:06:14.090 --> 00:06:16.700
He has roughly about this much
right here to lend-- and so

00:06:16.700 --> 00:06:18.620
the obvious thing, since there's
only two banks in this

00:06:18.620 --> 00:06:21.470
universe, is that this guy
would lend to that guy,

00:06:21.470 --> 00:06:23.570
probably overnight because you
don't know what's going to

00:06:23.570 --> 00:06:24.160
happen tomorrow.

00:06:24.160 --> 00:06:25.320
Maybe some people are
going to want their

00:06:25.320 --> 00:06:26.140
money back, et cetera.

00:06:26.140 --> 00:06:28.120
So we're just lending
overnight.

00:06:28.120 --> 00:06:30.053
And if this guy still feels
comfortable with the

00:06:30.053 --> 00:06:32.860
situation, he can continue
that lending.

00:06:32.860 --> 00:06:34.490
This guy can renew his
lending and this guy

00:06:34.490 --> 00:06:35.200
will renew it-- whatever.

00:06:35.200 --> 00:06:36.470
You get the idea.

00:06:36.470 --> 00:06:39.670
So the question is, what
interest rate does this guy

00:06:39.670 --> 00:06:43.350
charge to that guy for lending
this little chunk of money?

00:06:53.830 --> 00:06:56.520
Let's just say right now, this
bank says, well, I'll charge

00:06:56.520 --> 00:07:06.650
you-- I don't know-- I'll charge
you 10% overnight.

00:07:06.650 --> 00:07:09.480
So it's not like you're paying
10% just for a one night loan.

00:07:09.480 --> 00:07:11.300
It's an annual rate of 10%.

00:07:11.300 --> 00:07:16.110
So overnight, you're paying
this to the 1/365 power or

00:07:16.110 --> 00:07:17.350
however many business
days there are.

00:07:17.350 --> 00:07:19.770
So it's actually a very small
amount of interest. These are

00:07:19.770 --> 00:07:21.840
kind of the annual rates if
this guy were to continue

00:07:21.840 --> 00:07:25.510
borrowing it overnight and
overnight for a whole year.

00:07:25.510 --> 00:07:28.280
With that said, let's say that
the Fed decides the money

00:07:28.280 --> 00:07:30.440
supply isn't big enough.

00:07:30.440 --> 00:07:33.360
That the Fed wants to expand
the money supply.

00:07:33.360 --> 00:07:35.170
So let's see what happens
in that situation.

00:07:35.170 --> 00:07:37.175
So what was that mechanism?

00:07:37.175 --> 00:07:43.495
So what the Fed does is,
it can print notes.

00:07:46.770 --> 00:07:48.280
Let's just say it's actual
physical cash.

00:07:52.140 --> 00:07:55.480
That's an asset that the
Fed is holding now.

00:07:55.480 --> 00:07:58.290
And of course it has an
offsetting liability now,

00:07:58.290 --> 00:08:02.980
which is notes outstanding,
right?

00:08:02.980 --> 00:08:07.030
And then what the Fed does is,
it uses these notes and it can

00:08:07.030 --> 00:08:09.340
buy treasuries, it
can buy risk free

00:08:09.340 --> 00:08:12.780
government debt, right?

00:08:12.780 --> 00:08:15.260
And it buys them in
the open market.

00:08:15.260 --> 00:08:17.560
That debt might be being
held by China.

00:08:17.560 --> 00:08:19.960
It might be being held
by your grandmother.

00:08:19.960 --> 00:08:21.880
It could be being
held by anyone.

00:08:21.880 --> 00:08:25.100
It might even be being held by
some of these banks, but

00:08:25.100 --> 00:08:28.330
needless to say, they take
this and they buy

00:08:28.330 --> 00:08:31.730
treasuries with it.

00:08:31.730 --> 00:08:35.909
So then that asset then turns
to treasuries on the Fed's

00:08:35.909 --> 00:08:37.350
balance sheet.

00:08:37.350 --> 00:08:39.860
But where did all that
cash go, right?

00:08:39.860 --> 00:08:43.470
Well, that cash will then go
to your grandmother who was

00:08:43.470 --> 00:08:44.690
holding the treasuries.

00:08:44.690 --> 00:08:47.340
And what is your grandmother
going to do with that cash?

00:08:47.340 --> 00:08:50.020
Well, your grandmother is going
to put that cash in

00:08:50.020 --> 00:08:51.590
their bank, right?

00:08:51.590 --> 00:08:53.280
And maybe they're buying it
from a lot of people's

00:08:53.280 --> 00:08:54.620
grandmothers.

00:08:54.620 --> 00:08:57.090
And so let's say some of the
grandmothers put the

00:08:57.090 --> 00:09:03.860
money in this bank.

00:09:03.860 --> 00:09:04.670
I'm trying to draw it.

00:09:04.670 --> 00:09:07.240
So this bank gets a little
bit more reserves.

00:09:07.240 --> 00:09:12.160
And then some of the
grandmothers put it in this

00:09:12.160 --> 00:09:16.280
bank over here, right?

00:09:16.280 --> 00:09:17.530
And so what happened?

00:09:17.530 --> 00:09:19.390
What was the net
effect of that?

00:09:19.390 --> 00:09:21.790
The government's balance sheet
increased a little bit.

00:09:21.790 --> 00:09:23.100
If you look at its total
assets, it's

00:09:23.100 --> 00:09:23.980
expanded a little bit.

00:09:23.980 --> 00:09:26.170
Or if you actually just look
at its total liabilities.

00:09:26.170 --> 00:09:28.330
Its balance sheet grew.

00:09:28.330 --> 00:09:31.390
It took on some treasuries-- and
we'll have a whole video

00:09:31.390 --> 00:09:34.970
on what the impact on treasury
interest rates that does.

00:09:34.970 --> 00:09:36.550
But in the process, when it
bought those treasuries on the

00:09:36.550 --> 00:09:39.070
open market, more cash
got deposited

00:09:39.070 --> 00:09:40.630
into the banking system.

00:09:40.630 --> 00:09:43.970
And this could be cash or it
could be reserves with the

00:09:43.970 --> 00:09:44.960
central bank.

00:09:44.960 --> 00:09:47.770
But now let's think about
this situation

00:09:47.770 --> 00:09:49.270
between these two banks.

00:09:49.270 --> 00:09:53.910
Now all of a sudden this bank
here needs less money, right,

00:09:53.910 --> 00:09:56.210
because he got some reserve
deposits from our

00:09:56.210 --> 00:09:57.460
grandmothers.

00:09:57.460 --> 00:10:01.930
And also, this bank-- maybe now
this guy went from 10%--

00:10:01.930 --> 00:10:05.730
maybe now he has a 12% reserve
ratio because he got some

00:10:05.730 --> 00:10:07.250
deposits of actual cash.

00:10:07.250 --> 00:10:14.160
And maybe this guy went from 20%
to-- I don't know-- 22%.

00:10:14.160 --> 00:10:17.720
So now this guy needs
less money, right?

00:10:17.720 --> 00:10:21.686
His demand for money has been
lowered, or for cash has been

00:10:21.686 --> 00:10:24.440
lowered, or his demand for
reserves has been lowered.

00:10:24.440 --> 00:10:27.200
And this guy has even
more to lend, right?

00:10:27.200 --> 00:10:29.340
He already had a surplus and
now he has an even bigger

00:10:29.340 --> 00:10:30.650
surplus, right?

00:10:30.650 --> 00:10:33.790
So the supply of reserves
has increased

00:10:33.790 --> 00:10:35.460
in the banking system.

00:10:35.460 --> 00:10:39.720
The supply his increased from
the lending bank and the

00:10:39.720 --> 00:10:43.310
demand from the borrowing
bank has lowered.

00:10:43.310 --> 00:10:46.130
So now for this transaction to
occur, the demand has gone

00:10:46.130 --> 00:10:48.180
down, the supply has gone up.

00:10:48.180 --> 00:10:50.180
The price has got
to go down for a

00:10:50.180 --> 00:10:51.600
little borrowing overnight.

00:10:51.600 --> 00:10:53.140
And what is the price
of borrowing?

00:10:53.140 --> 00:10:54.510
Well, that's interest rates.

00:10:54.510 --> 00:10:58.780
So now for this transaction to
occur, all of a sudden maybe

00:10:58.780 --> 00:11:01.160
this guy needs it less, this
guy wants to lend even more

00:11:01.160 --> 00:11:01.850
because he has more.

00:11:01.850 --> 00:11:03.530
So now maybe this transaction
will occur at

00:11:03.530 --> 00:11:07.280
an 8% interest rate.

00:11:07.280 --> 00:11:12.080
And maybe the Fed has
a target rate of 5%.

00:11:12.080 --> 00:11:14.510
They want to see a reality where
this bank is lending to

00:11:14.510 --> 00:11:17.880
that bank at a 5% rate.

00:11:17.880 --> 00:11:18.820
So what would they do?

00:11:18.820 --> 00:11:21.940
Well, they would just keep
doing this process.

00:11:21.940 --> 00:11:23.760
They would issue a
little bit more.

00:11:23.760 --> 00:11:24.720
I realize I'm not going
to have time.

00:11:24.720 --> 00:11:25.580
But you see the process.

00:11:25.580 --> 00:11:28.450
They'd issue some more notes,
buy some more treasuries.

00:11:28.450 --> 00:11:30.430
Those notes would end up in
the banking system so the

00:11:30.430 --> 00:11:33.730
demand for overnight lending
will go down and there'll be

00:11:33.730 --> 00:11:35.220
more of those reserves
out there.

00:11:35.220 --> 00:11:37.430
So the rate at which
people lend to each

00:11:37.430 --> 00:11:38.740
other will go down.

00:11:38.740 --> 00:11:41.570
Anyway, I'll see you
in the next video.


Banking 13: Open Market Operations

WEBVTT
Kind: captions
Language: en

00:00:00.650 --> 00:00:04.650
In the last video, I hinted
that this was leading to a

00:00:04.650 --> 00:00:07.940
discussion of an elastic money
supply-- or a supply of money

00:00:07.940 --> 00:00:10.890
that can change depending on
the needs for the money.

00:00:10.890 --> 00:00:13.340
So before we go there-- and I
took a little hiatus and told

00:00:13.340 --> 00:00:14.880
you a little bit about
treasuries because that's a

00:00:14.880 --> 00:00:17.710
critical component-- let's
review what the

00:00:17.710 --> 00:00:19.400
money supply even is.

00:00:19.400 --> 00:00:21.030
So there were two definitions.

00:00:21.030 --> 00:00:25.050
When we had originally talked
about kind of an M0, I talked

00:00:25.050 --> 00:00:28.530
about just the gold reserves,
but now we're going to expand

00:00:28.530 --> 00:00:31.640
that definition a little bit
and I think you can tell--

00:00:31.640 --> 00:00:33.650
I've got a lot of questions
about this-- eventually

00:00:33.650 --> 00:00:37.990
getting off the gold reserve
system and we will get there

00:00:37.990 --> 00:00:41.070
and we're kind of already there,
but now I'll consider

00:00:41.070 --> 00:00:44.400
the base money supply
as Federal Reserve

00:00:44.400 --> 00:00:45.640
deposits and notes.

00:00:45.640 --> 00:00:49.570
So in this reality that I just
created, all of the Federal

00:00:49.570 --> 00:00:52.340
Reserve deposits have
essentially been turned into

00:00:52.340 --> 00:00:55.180
notes, but if this bank didn't
want all cash, it could have

00:00:55.180 --> 00:00:58.600
had some of this as just a
checking account with the

00:00:58.600 --> 00:01:00.140
Federal Reserve bank.

00:01:00.140 --> 00:01:03.230
So a Federal Reserve note and
a Federal Reserve deposit

00:01:03.230 --> 00:01:05.140
account is essentially
the same thing.

00:01:05.140 --> 00:01:06.940
A note is just a little
bit more fungible.

00:01:06.940 --> 00:01:09.110
You can hand it to someone and
then they can hand it to

00:01:09.110 --> 00:01:12.760
someone else, while a checking
account or demand account with

00:01:12.760 --> 00:01:14.820
the Federal Reserve bank, you
have to kind of do a wire

00:01:14.820 --> 00:01:18.330
transfer or write a check, et
cetera, but that is the base

00:01:18.330 --> 00:01:18.930
money supply.

00:01:18.930 --> 00:01:20.150
You could call that
base money.

00:01:20.150 --> 00:01:25.980
And that's essentially the size
of the liabilities of the

00:01:25.980 --> 00:01:28.510
Federal Reserve, in very broad
terms. We'll go into detail on

00:01:28.510 --> 00:01:30.000
the actual Federal
Reserve's balance

00:01:30.000 --> 00:01:31.130
sheet in the near future.

00:01:31.130 --> 00:01:35.860
So in this example right now,
our base money supply is 200--

00:01:35.860 --> 00:01:37.020
let's call it dollars now.

00:01:37.020 --> 00:01:38.340
Let's move away from
gold pieces.

00:01:38.340 --> 00:01:40.930
Let's just say a dollar equals
a gold piece for the sake of

00:01:40.930 --> 00:01:43.880
our instruction right now.

00:01:43.880 --> 00:01:47.260
So our base money supply--
and I'll call that M0.

00:01:51.610 --> 00:01:55.310
And that's the cash out there,
which are the Federal Reserve

00:01:55.310 --> 00:01:57.870
notes plus the Federal Reserve
demand deposits.

00:01:57.870 --> 00:02:01.100
So for example, this could have
been just 100, like a

00:02:01.100 --> 00:02:04.140
checking account at the reserve
bank and then this

00:02:04.140 --> 00:02:06.800
over here would have been a
checking account instead.

00:02:06.800 --> 00:02:09.330
But it would still be considered
part of the base

00:02:09.330 --> 00:02:11.830
money supply because if this
bank, who had a checking

00:02:11.830 --> 00:02:14.880
account, says, I just want that
in terms of notes, then

00:02:14.880 --> 00:02:17.350
the Federal Reserve bank will
just issue notes and cancel

00:02:17.350 --> 00:02:19.330
out this checking account and it
would turn back into notes.

00:02:19.330 --> 00:02:20.150
So they're equivalent.

00:02:20.150 --> 00:02:22.630
They're just a different way
of keeping track of it.

00:02:22.630 --> 00:02:24.870
So that's the base
money supply.

00:02:24.870 --> 00:02:26.740
Now, a slightly broader
definition

00:02:26.740 --> 00:02:27.840
of the money supply.

00:02:27.840 --> 00:02:29.585
We could call this bank money.

00:02:29.585 --> 00:02:33.160
It's sometimes referred to as
that and the formal definition

00:02:33.160 --> 00:02:38.740
is M1-- and that's essentially
that notion that I went over I

00:02:38.740 --> 00:02:41.000
think almost 10 videos ago--
how much money do

00:02:41.000 --> 00:02:42.440
people think they have?

00:02:42.440 --> 00:02:46.810
And that's the amount of money
in demand deposit accounts.

00:02:46.810 --> 00:02:50.670
So that in this case,
that's this.

00:02:50.670 --> 00:02:53.890
So all the people in this bank,
they think they have

00:02:53.890 --> 00:02:57.360
$100 there, right?

00:02:57.360 --> 00:02:59.500
That's $100 that they think that
they have that they can

00:02:59.500 --> 00:03:02.450
write checks against.
And then this bank

00:03:02.450 --> 00:03:05.710
also has another $100.

00:03:05.710 --> 00:03:12.820
And so the base money supply--
no, that's not right.

00:03:12.820 --> 00:03:13.420
No, no, sorry.

00:03:13.420 --> 00:03:14.530
They don't have $100.

00:03:14.530 --> 00:03:17.180
Why am I saying $100?

00:03:17.180 --> 00:03:17.460
Let's see.

00:03:17.460 --> 00:03:23.750
This bank had $100 in gold and
it could lend out up to $200

00:03:23.750 --> 00:03:26.700
in-- or it could put
out up to $200 in

00:03:26.700 --> 00:03:27.830
checking deposit accounts.

00:03:27.830 --> 00:03:30.220
So it has $200.

00:03:30.220 --> 00:03:32.850
Right, that's what I was--
because we talked about

00:03:32.850 --> 00:03:35.670
earlier in the last video that
we have a 50% reserve ratio,

00:03:35.670 --> 00:03:40.290
which tells us that if this
bank has $100 in reserves,

00:03:40.290 --> 00:03:46.130
that it can essentially manage--
or it can issue $200

00:03:46.130 --> 00:03:47.810
in demand deposit accounts.

00:03:47.810 --> 00:03:51.010
And we went over that many times
on how that happens.

00:03:51.010 --> 00:03:52.350
And then this bank
can do the same.

00:03:52.350 --> 00:03:56.040
It'll have $200 in demand
deposit accounts.

00:03:56.040 --> 00:03:58.790
And so the total amount of money
that people think they

00:03:58.790 --> 00:04:04.150
have, either in demand deposit
accounts-- in this situation,

00:04:04.150 --> 00:04:06.330
I'm assuming that all of the
cash is sitting in the reserve

00:04:06.330 --> 00:04:08.330
bank, although we do know that
some of this is going to be

00:04:08.330 --> 00:04:09.490
sitting around circulating.

00:04:09.490 --> 00:04:11.530
But let's just say we live in
a world where everyone uses

00:04:11.530 --> 00:04:13.670
debit cards all the time
and no-one uses cash.

00:04:13.670 --> 00:04:15.870
And I think we're heading to
that world very quickly.

00:04:15.870 --> 00:04:18.410
And as we'll see soon, that
actually increases the money

00:04:18.410 --> 00:04:19.339
supply when you do that.

00:04:19.339 --> 00:04:21.740
But anyway, I don't want to
go too technical just yet.

00:04:21.740 --> 00:04:24.950
But the M1, which is the total
amount of demand deposit

00:04:24.950 --> 00:04:29.540
accounts in our universe,
is $400.

00:04:29.540 --> 00:04:32.660
And this relationship makes
a lot of sense because our

00:04:32.660 --> 00:04:34.410
reserve requirements are 50%.

00:04:34.410 --> 00:04:38.190
So we can kind of assume that
banks tend to get as close to

00:04:38.190 --> 00:04:40.890
their reserve requirement as
they can because they don't

00:04:40.890 --> 00:04:43.390
get interest on reserves.

00:04:43.390 --> 00:04:47.200
They make interest on the loans
that they make against

00:04:47.200 --> 00:04:48.540
demand accounts.

00:04:48.540 --> 00:04:52.090
So if the reserve requirement
were 10% and our base money

00:04:52.090 --> 00:04:56.550
was $200, we would probably see
$2,000 in the M1 supply.

00:04:56.550 --> 00:04:59.840
So my question to you is-- and
maybe you want to pause and

00:04:59.840 --> 00:05:03.470
think about this is-- how can
the government or the central

00:05:03.470 --> 00:05:06.930
bank or, how can the economy,
increase or

00:05:06.930 --> 00:05:08.470
decrease the money supply?

00:05:08.470 --> 00:05:11.110
And I guess the first question
is, why would you want to

00:05:11.110 --> 00:05:13.420
increase or decrease
the money supply?

00:05:13.420 --> 00:05:16.060
Well, let's say we're in this
world already and we only have

00:05:16.060 --> 00:05:16.810
these two banks.

00:05:16.810 --> 00:05:20.250
And we have an M1
supply of $400.

00:05:20.250 --> 00:05:22.130
But let's say the
economy expands.

00:05:22.130 --> 00:05:23.590
We have more goods
and services that

00:05:23.590 --> 00:05:24.260
we're able to produce.

00:05:24.260 --> 00:05:27.140
Maybe we have immigrants come
in so we have more labor.

00:05:27.140 --> 00:05:31.150
Maybe we have some innovative
technology.

00:05:31.150 --> 00:05:32.110
Or maybe it's just seasonal.

00:05:32.110 --> 00:05:35.600
Maybe it's the crop planting
season so a lot of farmers

00:05:35.600 --> 00:05:37.830
need their cash in order
to hire people

00:05:37.830 --> 00:05:38.920
to plant the crops.

00:05:38.920 --> 00:05:40.800
So that's another time where
you'd want more money.

00:05:40.800 --> 00:05:44.120
If you don't increase the money
supply at those times

00:05:44.120 --> 00:05:46.220
when you have economic expansion
or there's just more

00:05:46.220 --> 00:05:49.260
demand because of some type of
seasonal fluctuaction-- if you

00:05:49.260 --> 00:05:52.340
don't increase the money, then
what you're going to do is

00:05:52.340 --> 00:05:54.620
money's going to become
more expensive.

00:05:54.620 --> 00:05:56.390
And I'll do a whole video
on that so don't get too

00:05:56.390 --> 00:05:58.550
confused, but money getting
more expensive means that

00:05:58.550 --> 00:06:00.200
interest rates will go up.

00:06:00.200 --> 00:06:02.510
And if money becomes too
expensive, then some good

00:06:02.510 --> 00:06:05.470
projects, maybe some farmers who
might have planted seeds,

00:06:05.470 --> 00:06:07.970
wouldn't be able to-- and so
you would kind of restrict

00:06:07.970 --> 00:06:09.070
economic expansion.

00:06:09.070 --> 00:06:12.090
But we'll have a whole other
discussion on when does it

00:06:12.090 --> 00:06:13.750
make sense to expand
or contract money.

00:06:13.750 --> 00:06:16.820
Let's just talk now about how
you would actually do it.

00:06:16.820 --> 00:06:17.860
So there's two ways.

00:06:17.860 --> 00:06:21.550
I just said if this reserve
requirement were 10%, then

00:06:21.550 --> 00:06:24.200
these banks could create more
checking accounts, right?

00:06:24.200 --> 00:06:26.090
They could lend out more money
and create more checking

00:06:26.090 --> 00:06:28.460
accounts if the reserve
requirement were 10%.

00:06:28.460 --> 00:06:34.130
If it was 10%, then you would
have an M1 of $2,000, right?

00:06:34.130 --> 00:06:36.256
It would be 10 times this
instead of two times this.

00:06:38.770 --> 00:06:41.410
And that is considered one of
the tools of the Federal

00:06:41.410 --> 00:06:42.040
Reserve bank.

00:06:42.040 --> 00:06:44.790
Because we've said in the past
that the Federal Reserve bank

00:06:44.790 --> 00:06:47.640
actually sets these reserve
requirements.

00:06:47.640 --> 00:06:49.680
But the problem with that tool,
if you think about it,

00:06:49.680 --> 00:06:54.670
is, if we made a reserve
requirement 10%, right?

00:06:54.670 --> 00:06:56.970
And all of a sudden all of these
banks started lending a

00:06:56.970 --> 00:06:58.840
lot more money and they
only had 10%.

00:06:58.840 --> 00:07:02.460
The ratio of reserves to
checking accounts were 10%.

00:07:02.460 --> 00:07:04.430
Think about what would happen
if we wanted to raise the

00:07:04.430 --> 00:07:07.630
reserve requirement
back to 50%.

00:07:07.630 --> 00:07:10.150
Then all of the banks-- they'd
only have 10% reserves.

00:07:10.150 --> 00:07:13.540
How would they get
back to 50%?

00:07:13.540 --> 00:07:17.570
All of these banks would have to
either start selling assets

00:07:17.570 --> 00:07:18.690
or unwinding loans.

00:07:18.690 --> 00:07:20.330
It would be a very
messy situation.

00:07:20.330 --> 00:07:22.850
If you were to lower the reserve
requirement and then

00:07:22.850 --> 00:07:24.880
wanted to actually increase it
again, you would actually make

00:07:24.880 --> 00:07:28.640
a lot of banks become
undercapitalized, because most

00:07:28.640 --> 00:07:30.630
banks just operate right
at where they need to.

00:07:30.630 --> 00:07:32.820
So you really don't want to mess
around with this reserve

00:07:32.820 --> 00:07:34.660
requirement much.

00:07:34.660 --> 00:07:36.830
So the question is, if you're
not going to change the

00:07:36.830 --> 00:07:41.510
reserve requirement, which is
the ratio of the reserves to

00:07:41.510 --> 00:07:44.030
checking accounts, if you're not
going to mess with that,

00:07:44.030 --> 00:07:46.320
the only other way that you
can actually increase the

00:07:46.320 --> 00:07:49.420
number of checking accounts is
if somehow you can increase

00:07:49.420 --> 00:07:50.600
the reserves.

00:07:50.600 --> 00:07:56.120
If you can somehow add some
actual reserves over here.

00:07:56.120 --> 00:07:58.210
So my question is, how
can you do that?

00:07:58.210 --> 00:08:01.480
Well, let's just say that--
we're hopefully already

00:08:01.480 --> 00:08:05.180
reasonably familiar with
fractional reserve banking.

00:08:05.180 --> 00:08:08.770
So you might have seen it
coming, that that also applies

00:08:08.770 --> 00:08:09.790
to the central bank.

00:08:09.790 --> 00:08:12.110
So the central bank right now,
all of its deposits were

00:08:12.110 --> 00:08:14.910
directly backed by gold, 1:1.

00:08:14.910 --> 00:08:19.400
But there's nothing to stop
this bank from also doing

00:08:19.400 --> 00:08:21.130
fractional reserve lending.

00:08:21.130 --> 00:08:24.970
And actually, the central bank
has no reserve requirement.

00:08:24.970 --> 00:08:27.690
And that's because to some
degree, it can always provide

00:08:27.690 --> 00:08:31.180
the liquidity because its notes
are obligations of the

00:08:31.180 --> 00:08:31.630
government.

00:08:31.630 --> 00:08:36.059
So it can always tax more people
to back up its loans.

00:08:36.059 --> 00:08:39.700
So what essentially the Federal
Reserve can do is--

00:08:39.700 --> 00:08:44.159
and this is the printing press
of the base money supply that

00:08:44.159 --> 00:08:45.190
people talk about.

00:08:45.190 --> 00:08:46.460
But there's two printing
presses.

00:08:46.460 --> 00:08:48.640
There's the base money printing
press and then

00:08:48.640 --> 00:08:50.750
there's the leverage
printing press.

00:08:50.750 --> 00:08:53.170
So if this increases-- well,
I'll do a whole video on that

00:08:53.170 --> 00:08:54.950
another-- I don't want to get
too technical because I

00:08:54.950 --> 00:08:57.930
realize I'm running
out of time.

00:08:57.930 --> 00:09:01.880
So what the Federal Reserve
could do in this situation is

00:09:01.880 --> 00:09:05.690
it can print some notes.

00:09:05.690 --> 00:09:09.450
So let's say it prints 100 of
the notes, right, and those

00:09:09.450 --> 00:09:11.360
are just-- it literally just
prints those dollars.

00:09:11.360 --> 00:09:14.260
It pays the treasury to print
it for them, but it creates

00:09:14.260 --> 00:09:17.400
these notes and then of course,
offsetting that is a

00:09:17.400 --> 00:09:19.000
liability, right?

00:09:19.000 --> 00:09:23.190
Notes outstanding,
100 liability.

00:09:23.190 --> 00:09:26.990
And then what it does is, it
takes these $100-- I mean,

00:09:26.990 --> 00:09:30.290
these are literally dollar bills
although it could be

00:09:30.290 --> 00:09:33.540
some type of demand account or
whatever, but take these $100

00:09:33.540 --> 00:09:38.220
bills that it printed and
then it can buy treasury

00:09:38.220 --> 00:09:39.170
securities.

00:09:39.170 --> 00:09:41.920
So what happens if it takes
these $100 bills and buys

00:09:41.920 --> 00:09:44.350
treasuries?

00:09:44.350 --> 00:09:45.790
And the treasuries don't
have to be issued by

00:09:45.790 --> 00:09:46.630
the government anymore.

00:09:46.630 --> 00:09:48.630
Because whenever the government
does issue

00:09:48.630 --> 00:09:50.760
treasuries, it's bought
by just a bunch of

00:09:50.760 --> 00:09:53.310
people in the world.

00:09:53.310 --> 00:09:55.340
There's always a bunch of
treasuries sitting out there

00:09:55.340 --> 00:09:57.300
as long as the treasury
has some debt.

00:09:57.300 --> 00:09:59.650
So I was holding the treasuries
and let's say that

00:09:59.650 --> 00:10:00.900
this is the central bank.

00:10:04.510 --> 00:10:07.780
I was holding some some of these
government IOUs, right,

00:10:07.780 --> 00:10:09.820
that I had bought from
the government.

00:10:09.820 --> 00:10:17.630
And the Federal Reserve,
they have this $100.

00:10:17.630 --> 00:10:18.880
Let me draw that in green.

00:10:22.700 --> 00:10:26.300
So they just buy the
treasury from me.

00:10:26.300 --> 00:10:28.640
Maybe I don't want to sell it
at the current price so they

00:10:28.640 --> 00:10:30.610
have to pay me a little bit more
than the current price in

00:10:30.610 --> 00:10:32.610
order for me to part with it--
and I'll do a whole other

00:10:32.610 --> 00:10:35.510
video on what that means and
how that changes the yield

00:10:35.510 --> 00:10:38.310
curve and all of that, but I
just want to get you to that

00:10:38.310 --> 00:10:42.610
base notion that the treasury
essentially creates a notes

00:10:42.610 --> 00:10:46.530
outstanding liability and has
an offsetting $100 of dollar

00:10:46.530 --> 00:10:50.160
bills that it just created or
prints-- and then it can use

00:10:50.160 --> 00:10:53.700
those $100 bills to buy
treasuries, or government

00:10:53.700 --> 00:10:55.910
IOUs, in the open market.

00:10:55.910 --> 00:10:57.510
And now what happens here?

00:10:57.510 --> 00:10:59.820
Well, these $100 bills, these
are now treasuries.

00:11:04.060 --> 00:11:06.450
And my question to you
is, what am I-- I

00:11:06.450 --> 00:11:07.430
was holding a treasury.

00:11:07.430 --> 00:11:08.730
It was sitting in my mattress.

00:11:08.730 --> 00:11:10.790
What am I now going-- now
I don't have a treasury.

00:11:10.790 --> 00:11:12.190
I have $100.

00:11:12.190 --> 00:11:14.430
What am I going to do
with that $100?

00:11:14.430 --> 00:11:16.950
Well, I'm going to deposit
it in the bank.

00:11:16.950 --> 00:11:18.530
I'm going to deposit
it in the bank.

00:11:18.530 --> 00:11:21.480
So this is me depositing
my $100.

00:11:21.480 --> 00:11:25.100
Maybe I deposited it up here,
but-- and my checking account

00:11:25.100 --> 00:11:27.520
grows a little bit, but
what's the net effect?

00:11:27.520 --> 00:11:31.030
Now all of a sudden the banking
system, the national

00:11:31.030 --> 00:11:34.500
banking system, has more
currency, more dollar

00:11:34.500 --> 00:11:36.860
reserves, that apply to
its reserve ratio.

00:11:36.860 --> 00:11:39.470
So now it got my $100 deposit.

00:11:39.470 --> 00:11:42.140
Now it can also do another
$100 of lending.

00:11:42.140 --> 00:11:45.370
So I would have essentially
increased the base-- so now

00:11:45.370 --> 00:11:50.550
the M0 goes from $200 to $300
right, because I have $300 in

00:11:50.550 --> 00:11:51.670
notes outstanding.

00:11:51.670 --> 00:11:54.960
And now my M1-- I took that $100
bill that the treasury

00:11:54.960 --> 00:11:57.160
gave me, deposited it
in a bank account.

00:11:57.160 --> 00:12:00.520
Now I have a bank account that
says $100 and then because of

00:12:00.520 --> 00:12:04.150
a 50% reserve requirement, the
bank can issue another loan.

00:12:04.150 --> 00:12:05.820
I know it's getting messy.

00:12:05.820 --> 00:12:10.690
$400-- so essentially
our M1 is now $600.

00:12:10.690 --> 00:12:14.780
So just like that, just by
printing money and issuing

00:12:14.780 --> 00:12:20.890
treasuries, the central
bank was able to

00:12:20.890 --> 00:12:23.880
increase the M1 by $200.

00:12:23.880 --> 00:12:24.940
I'll do more videos on this.

00:12:24.940 --> 00:12:25.910
I don't want to confuse
you too much.

00:12:25.910 --> 00:12:27.420
See you soon.