The Discount Rate발음듣기
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The Discount Rate
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And then we can move into something that you've probably heard in the same context, and they're often confused, and that's the discount rate.발음듣기
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So let's say that I have - and I won't draw the balance sheets every time now - let's say I have Bank One and this is Bank Number Two.발음듣기
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I was already using green, but I'll do that in gold just so we can reminisce about the gold standard.발음듣기
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And let's say right now that Bank One is willing to lend it to Bank Two if Bank Two pays Bank One a 6% overnight rate.발음듣기
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That's above our target rate. We want banks to lend to each other for a lower interest rate, so we want to do open market transactions or open market operations to lower this rate.발음듣기
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So let's say that this is the Fed's current assets - and in a couple of videos, I'll actually show you what the Fed's balance sheet looked like before all this craziness started and what it looks like now, but that's the Federal reserve's assets.발음듣기
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This is their liabilities. And then their liabilities are going to be a little bit smaller then their assets and they have a little equity.발음듣기
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But the mechanism that the Fed uses to do these open market operations is they essentially print money.발음듣기
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So what the Federal reserve will do is, they will create some notes or some actual reserves.발음듣기
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So these are Federal reserve notes - or as we know them, the dollar bills that are sitting in your wallet or the things that could be converted to dollar bills that are sitting in your bank account, the bits and bytes in some computer database someplace.발음듣기
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They have to have an offsetting liability and their offsetting liability are Federal reserve notes outstanding.발음듣기
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And this is issued even though these Federal reserve notes - I'll circle it in yellow - are issued by the Federal reserve bank.발음듣기
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We've talked a lot about what that means, but needless to say, we're just going over the mechanics.발음듣기
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So what they'll do is they'll take these dollars now and they'll use these dollars to go buy treasuries from people out in the world.발음듣기
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It could be me. It could be my grandfather. It could be even some of these banks and so let's say that there's - right now somebody is holding a treasury.발음듣기
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And then I'm no longer holding a T-bill, right, because I sold it to the Federal reserve bank.발음듣기
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Just for the sake of simplicity, I deposit some of it in this bank account and let's say I deposit some of it in this bank account, just for simplicity.발음듣기
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We know that if you need something less, but people have more of it, the price of buying it or borrowing it is going to go down.발음듣기
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So this guy has more of it and this guy needs it less, all of a sudden this guy's not willing to pay 6% to borrow it.발음듣기
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And this guy's actually more desperate to offload some of these reserves and get some interest on it.발음듣기
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So this guy's going to lower the rate he'll charge and this guy's going to lower the rate he's willing to pay and maybe it goes down to 5%.발음듣기
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Let's say whatever happens, rates are at 3% and the Federal reserve doesn't like that and wants to raise the Federal funds rate, which is the target rate that banks lend to each other, then they can do the opposite thing.발음듣기
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And they'll sell it, right? So they'll take this T-bill and they'll sell it to someone else - maybe this guy right here.발음듣기
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Let's say his dollar bills are sitting at one of - he's got a couple there and couple there.발음듣기
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So when the Federal reserve sells this T-bill to this guy, this guy might do a wire transfer to that party - or a check or it doesn't matter, but either way you look at it, these reserves disappear and they go back into the Federal reserve.발음듣기
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When they go back into the Federal reserve, they offset this liability and then the currency essentially disappears, but the real result is that all of a sudden then demand would have gone up because there'd be fewer reserves in the system.발음듣기
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Demand goes up. And then the supply would have gone down because there's also fewer reserves in the system.발음듣기
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Now all of this works well assuming a world where banks are willing to lend to each other at some rate.발음듣기
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There's some rate at which this guy says, I'm willing to lend to this guy because I know he's going to pay me the next day and it's just a matter of just supply or demand.발음듣기
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They tend to be very short term loans so they tend to be very, very safe, but what happens in a world - let me draw the same two banks.발음듣기
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I think I overdrew. So this is Bank Number One and this is Bank Number Two - and Bank Number One had more reserves.발음듣기
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All of their depositors are starting to get scared and they're starting to pull their reserves out, right?발음듣기
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And we all know that these banks don't keep enough reserves to fulfill all of their deposits.발음듣기
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Depending on their reserve requirements, but they'll have some reserves in case people want to take out their money from their checking accounts--발음듣기
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and then the rest of these are assets that they invested in and the bank makes money by making more money on these assets than it has to pay out in interest.발음듣기
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Now what happens if this bank - its condition starts to get a little bit weak, people start to get afraid, and the deposits start to - people go to their ATM, start pulling their money out,발음듣기
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and if anything maybe they'll start depositing it into a safer bank or just stuffing it under their mattresses, right?발음듣기
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This bank says, all of a sudden I have a liquidity issue because, sure, maybe that much people withdraw their money.발음듣기
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I have enough reserves to pay that, but then if another guy comes along, that's going to deplete my reserves and then when the next guy comes along,발음듣기
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I'm not going to have any reserves left and it's going to be a full all-out panic when I - I told this guy that I could give him his money on demand and all of a sudden,발음듣기
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if I can't give him on demand, then we're going to have this huge banking panic and then everyone else is going to want their deposits,발음듣기
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In a normal situation like that, I'd say, hey, Bank Number One, I need some reserves and just like I did in the first half of this video, this guy would lend the reserves and then this guy would give this guy interest.발음듣기
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Because if this guy can't pay one of his depositors - and this is kind of a prime weakness of a fractional reserve system.발음듣기
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If there's just one weak link in the banking system and people lose confidence - maybe this guy was the only bad bank out there and people start taking all their money out.발음듣기
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The first guy who can't get his money back, he's going to call up the press and say, my God, the banks aren't good for the money.발음듣기
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Maybe there's a run on all the banks because people don't know which banks are good, which ones are bad.발음듣기
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And the Federal reserve in this situation now, they'll print notes - so Federal reserve notes or reserves, either way - and these are the notes outstanding liability.발음듣기
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They'll lend these notes to this guy and in exchange, this guy has to give some collateral to the Federal reserve.발음듣기
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It's essentially just - you're collateralizing a loan - and I'll do a whole video on what a repo transaction is, but the big picture is, this guy is desperate.발음듣기
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So he goes to the discount window and borrows directly from the Federal reserve as a lender of last resort.발음듣기
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And the rate at which he borrows - the interest that he pays this guy, that is the discount rate.발음듣기
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So that's the rate that a bank pays to the Federal reserve when it can't borrow from another bank overnight.발음듣기
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Because if the discount rate was less than the Federal funds rate, then you'd always have people using the discount window all of the time instead of borrowing from each other.발음듣기
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Historically the discount rate was about a percent higher than the Federal funds rate to encourage people to lend to each other or borrow from each other,발음듣기
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but in the recent past that spread is gone down and now all of the rates are almost zero, but we'll go into that in more detail, but it's a key differential.발음듣기
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When the Federal reserve talks about setting rates, they're usually talking about setting the Federal funds rate and the discount rate usually moves down with it, but it's always going to be a little bit higher than the Federal funds rate.발음듣기
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This is for everyday borrowing between banks to make sure that everyone has the reserves they need or they don't have too much and they can get interest on it.발음듣기
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