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

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