Summary
Highlights
The Fed employs several tools to manage the money supply. The first and most frequently used is 'open market operations', which involves the Federal Open Market Committee buying or selling US government bonds on the open market. To increase the money supply, the Fed buys bonds from the public, injecting money into the economy. To decrease it, the Fed sells bonds, withdrawing money. The second tool is changing the 'reserve requirement'. An increase in the reserve requirement decreases the money multiplier, reducing the money supply's expansionary potential. However, the Fed rarely uses this tool to avoid disrupting bank operations. The third tool is changing the 'discount rate', the interest rate at which banks can borrow from the Fed. An increase in the discount rate makes borrowing from the Fed more expensive, leading banks to hold more excess reserves and thus decreasing the money supply. The Fed frequently adjusts the discount rate.
The video concludes by discussing two main challenges the Fed faces in controlling the money supply. Firstly, the Fed cannot control the amount of money households choose to deposit in banks. If public confidence in banks declines, people might withdraw their money, shrinking the money supply. Secondly, the Fed does not directly control how much money banks actually lend out. Banks can choose to hold more reserves than required, which would reduce the money multiplier's effect. The importance of public confidence in the banking system is emphasized, and how the Fed works to stabilize the system and prevent bank runs is explained. The instructor mentions a Freakonomics podcast with Ben Bernanke about his challenges during the 2008 banking crisis and hints at discussing the Fed's role in the Great Depression in a future video, noting its past failures.
The video begins by defining money as a medium of exchange that has no intrinsic value itself but is used to acquire goods and services. It contrasts money with a barter system, highlighting money's efficiency due to its universal acceptance, eliminating the 'mutual coincidence of wants'. The economic definition of money is presented as 'the set of all assets in the economy that people regularly use to exchange for goods and services'. Three key functions of money are identified: as a medium of exchange, a unit of account (a common measure for prices and debts), and a store of value (though its effectiveness as a store of value is influenced by inflation). The concept of 'liquidity' is introduced, defining it as the speed with which an asset can be converted into the economy's medium of exchange.
The video distinguishes between two types of money: commodity money and fiat money. Commodity money is money that has intrinsic value, such as gold or silver, and historically, the US operated on a gold standard. Fiat money, which is what the US currently uses, derives its value from government decree (legal tender) and public faith in the government. The discussion then shifts to measuring the money supply in the US economy, introducing the 'money stock'. Key components of the money stock include currency (paper bills and coins) and demand deposits (checking accounts). The video explains M1, the most liquid measure, which includes currency, demand deposits, traveler's checks, and other checkable deposits, and M2, which includes M1 plus less liquid assets like savings deposits, money market mutual funds, and small time deposits. Approximate values for M1 and M2 in 2016 are provided to illustrate their scale.
The Federal Reserve System, or 'The Fed', is introduced as the central bank of the United States. Established in 1914 after a series of bank failures, its primary roles are to oversee the banking system, regulate banks, and control the money supply. The Fed's structure includes a Board of Governors (seven members appointed for 14-year terms to ensure political independence) and 12 regional banks. The chairman of the Fed serves a four-year term. The Fed clears checks and acts as the 'bankers' bank', making loans to other banks at an interest rate known as the 'discount rate', serving as a lender of last resort. The second major job is to control the quantity of money through monetary policy, which is set by the Federal Open Market Committee (FOMC).
The video explores the relationship between banks and the money supply, starting with a hypothetical scenario of an economy with no banks where the money supply is purely currency. It then introduces a 100% reserve banking system where a bank accepts deposits but lends nothing out, showing that the money supply's magnitude remains unchanged, merely shifting from currency to demand deposits. The concept of 'fractional reserve banking' is then introduced, where banks hold only a fraction of deposits in reserve and lend out the rest. The 'reserve ratio' is defined as the fraction of deposits banks hold, with the mandated minimum set by the Fed being the 'reserve requirement'. An example demonstrates how a bank, by lending out a portion of its deposits, effectively increases the money supply, creating money (but not wealth) and increasing the economy's liquidity. This process of money creation continues as loans are redeposited and re-lent.
To quantify the impact of fractional reserve banking on the money supply, the 'money multiplier' is introduced. This multiplier is the inverse of the reserve ratio (1/R). Using the previous example with a 10% reserve ratio, the money multiplier is 10, meaning an initial $100 deposit can generate $1,000 in the money supply. It is crucial to use the reserve ratio (as a fraction) rather than the percentage when calculating the money multiplier.