Monetary policy tools

0:00- [Instructor] Let's think about the actual monetary policy tools of a central bank, especially like the US Federal Reserve. So the first I will talk about is reserve ratios, and in particular, required reserve ratios. Now, what am I talking about here? Required reserve ratios.

0:20Well, in fractional reserve banking, which is how banking in most of the world happens, what happens is you have a bank, and let's say people put in, I don't know, a million dollars of deposits in this bank. Now, it turns out that the bank does not have to keep all $1 million on reserve.

0:42They have to keep some of it on reserve, but they could lend the rest out. And so a central bank in the US, it's the US Federal Reserve, decides what is that required amount of reserves. So let's say they were to say that you have to keep 10% in reserves. Well, that means that this bank would have to keep 100K in case someone comes to the bank and wants to withdraw their deposits, but the other 900K can be lent out.

1:08And when it gets lent out, that can be deposited either in the same bank again or in another bank. Let's imagine that. So it goes into another bank, and now that bank has 900K and it has to only keep 10% there so it can lend out, so it keeps 80, 10%, it keeps 90K there.

1:33And then it can lend out, let me make this, this is 900K that got lent out. Now this one can lend out 810K, and so on and so forth. And now you could imagine if instead of a 10% reserve requirement it was 20%. Well, now all of a sudden this would be 200K, and this over here would be 800K, and these numbers would be smaller.

1:57And so the reserve requirement, the required reserve ratios, actually just determines how much money is in the banking system in a fractional reserve system. So if the central bank wants to be more conservative and make sure there's a cushion of safety, they will up the required reserve ratios, or if they maybe wanna slow down the economy.

2:17And if they wanna speed things up and increase the money supply, they can lower the required reserve ratios. Now, another tool, and this is probably the one that people talk the most about, is the federal funds rate federal funds rate. We just talked about banks needing to keep reserves.

2:39Let's take our first example where they have to keep 10% in reserve. Well, what if a bank has a lot of withdrawals and they have trouble keeping 10% in reserves and they can't call all those loans back in? Well, they need to borrow money from someone else. Now, what typically happens is that these banks borrow reserves from each other, and that's overnight.

2:59And so the federal funds, they have a target rate for overnight borrowing, which oftentimes becomes a self-fulfilling prophecy. But the Federal Reserve can also be the borrower of last resort where banks can go directly to the Federal Reserve and borrow from them, so they can keep up their reserves.

3:17And you could imagine that the more money that is out there in reserves, the lower the federal funds rate. And then the less money that's out there, relative to the reserve requirements, the higher that rate becomes. And so the way that they actively make that federal funds rate a reality if the banks just don't do it on themselves, especially that target rate for overnight borrowing, is through what is known as open market operations.

3:46Open market operations. And so this is the situation where the Federal Reserve, let's say they want to increase the amount of money that's in circulation, which would lower the federal funds rate 'cause it would increase the amount of reserves, well, they can print money.

4:06And then how does that money get into circulation? Well, they buy assets out there in the open market. And typically, they will buy things like federal bonds, treasury bonds, T bills, things like that. And so when they buy, let's say I owned a T bill, I sell it to the Federal Reserve, then I take this money and I go and I deposit it into one of these banks.

4:28And so I've just increased that bank's reserves. They might be able to lend some of it out, and then that might increase another bank's reserves, et cetera, and since there's more reserves out there, the overnight borrowing between the banks might go down. So that's one way where the open market operations might help lower the federal funds rate.

4:45And they could do the opposite if they want that to go up. Now, there's also things that have happened, especially during crises, where the Federal Reserve might buy other types of assets. They might buy longer term debt. I don't wanna go into too much detail.

4:57They might even buy other types of securities just to get more cash into the system. But I won't go into a lot of detail into that. That's called quantitative easing. And then the last thing I'll mention, and this became very relevant after the 2008 financial crisis, is the interest on reserves.

5:16So these banks keep reserves with the Federal Reserve system, and the Federal Reserve actually will pay interest on it. So if it pays higher interest on those reserves, that provides an incentive for a bank to keep more reserves and not lend as much out. So as you can imagine, all four of these have an impact on how much money there is in the system, what interest rates, especially short-term interest rates, but that has an impact on long-term interest rates as well, which of course can affect the broader economy.