The discount rate Video Lecture | SSC CGL Tier 2 - Study Material, Online Tests, Previous Year

Let's do a little review of what
the Fed funds rate was.
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.
And they are related and they
kind of do move together.
They are pretty different in
their actual implementation.
So the Federal funds rate--
this is a target rate.
This is the target rate at
which the Federal reserve
wants banks to lend
to each other.
So let's say that I have-- and
I won't draw the balance
sheets every time now-- let's
say I have have Bank One and
this is Bank Number Two.
And let's say this bank
over here has
a surplus of reserves.
I was already using green, but
I'll do that in gold just so
we can reminisce about
the gold standard.
So let's say it has a surplus of
reserves and Bank Two needs
them, right?
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.
And let's say that the
Federal reserve, they
say, you know what?
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.
And the mechanics that they do
it by-- let's draw the Fed's
balance sheet.
I'll do them in magenta.
That's half of it and then
this is the other half.
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.
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.
Their equity's a little
different
than traditional equity.
There really isn't
a lot of upside.
You just get a dividend
on it, but we won't
go to details there.
But the mechanism that the Fed
uses to do these open market
operations is they essentially
print money.
So what the Federal reserve will
do is, they will create
some notes or some
actual reserves.
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.
And they can't create
it out of thin air.
They have to have an offsetting
liability and their
offsetting liability are
Federal reserve notes
outstanding.
This is just saying, hey,
we issued this.
If someone comes back to us,
we have this liability.
And this is issued even though
these Federal reserve notes--
I'll circle it in yellow--
are issued by the
Federal reserve bank.
They're backed by the full faith
and credit of the U.S.
government.
We've talked a lot about what
that means, but needless to
say, we're just going
over the mechanics.
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.
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.
I hold a T-bill.
The Federal reserve will use
that money-- let's say I own a
ton of T-bills.
I'm the richest man
in the country.
I could even be China.
China holds a lot of T-bills.
They buy the T-bill.
So then this becomes-- this
asset is no longer Federal
reserve notes.
It's now a T-bill.
And then I'm no longer holding
a T-bill, right, because I
sold it to the Federal
reserve bank.
I don't know I sold it to the
Federal reserve bank.
I just sold it in the market.
I don't know who bought it.
It might have been
another guy.
It might have been
another country.
But it happened to be in this
case the Federal reserve bank.
And now I'm holding reserves.
I'm holding money
as we know it.
I'm holding a Federal
reserve note.
And what am I going to do with
that Federal reserve note?
I'm going to deposit
it in banks, right?
And so I'm going to take this
Federal reserve note.
Let's say I have a couple
of bank accounts.
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.
So what happens now?
Now this guy has more notes
to lend out and
this guy needs less.
So demand has gone down.
This guy needs less.
So demand has gone down
from this guy.
And supply has gone
up from this guy.
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.
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.
And this guy's actually more
desperate to offload some of
these reserves and get
some interest on it.
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%.
And the Federal reserve can
keep buying or selling
treasuries to adjust
what this happens.
They could do the opposite.
If they said, wow, rates are
a little bit too low.
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.
They could take this
T-bill, right?
This was a T-bill.
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.
So this guy, he's got
a dollar bill.
So his dollar bills are
going to be sitting at
one of these banks.
Let's say his dollar bills are
sitting at one of-- he's got a
couple there and couple there.
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.
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.
Demand goes up.
And then the supply would have
gone down because there's also
fewer reserves in the system.
And now this guy, he's like,
wow, I have less to lend out.
I need more interest in order
for me lend it out.
And this guy says, wow, I'm more
desperate than ever to
borrow some reserves.
I'm willing to pay more and so
the rates will go up to 4%.
Now all of this works well
assuming a world where banks
are willing to lend to each
other at some rate.
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.
These tend to be overnight
loans.
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.
I think I overdrew.
So this is Bank Number One and
this is Bank Number Two-- and
Bank Number One had
more reserves.
Bank Number Two has fewer.
Bank Number Two needs
reserves.
Let's say people are worried
about Bank Number Two.
All of their depositors are
starting to get scared and
they're starting to pull their
reserves out, right?
And we all know that these
banks don't keep enough
reserves to fulfill all
of their deposits.
Actually, let me draw Bank
Number Two's balance sheet.
They have equity, hopefully.
They'll have some deposits.
Let's say all of these
are deposits.
They have to keep some
reserves, right,
so that's an asset.
Depending on their reserve
requirements, but they'll have
some reserves in case people
want to take out their money
from their checking accounts--
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. It makes money
on that spread.
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, and if anything
maybe they'll start
depositing it into a safer bank
or just stuffing it under
their mattresses, right?
This bank says, all of a sudden
I have a liquidity
issue because, sure, maybe
that much people withdraw
their money.
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,
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, 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 and then I'm
going to have this huge
liquidity crisis.
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.
But what if this guy is scared
of Bank Number Two too?
He's like, wow, that guy's
in a tough situation.
He's facing a liquidity
crisis.
I don't even know what
his assets are worth.
Maybe his assets are
actually shrinking.
And that's been happening
lately.
Maybe he made a bunch of
bad mortgage loans.
I don't want to lend
to this guy.
And this guy becomes a pariah
of the banking community.
No-one wants to lend
to this guy.
But at the same time, it's in
no-one's interest for there to
be a run on this bank.
Because if this guy can't pay
one of his depositors-- and
this is kind of a prime weakness
of a fractional
reserve system.
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.
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.
Maybe there's a run on all the
banks because people don't
know which banks are good,
which ones are bad.
So to prevent this, the Federal
reserve has something
called the discount window.
So let me draw the Federal
reserve's balance sheet again.
And the discount window is
essentially a lender of last
resort to the banks.
So there's some type of
Federal funds rate.
Let's say the Federal
funds rate is at 6%.
In a normal environment,
this guy would lend
to get back at 6%.
But let's say that's
broken and this
guy is really desperate.
He can actually go to the
Federal reserve and borrow
directly from the
Federal reserve.
So once again, these are the
assets of the Federal reserve.
These are the liabilities.
This is the equity of
the Federal reserve.
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.
And they will lend
it to this guy.
They'll lend these notes to this
guy and in exchange, this
guy has to give some collateral
to the Federal reserve.
So let's say he had some
other assets here
that are hard to sell.
He didn't want to sell
them in a hurry.
So he'll just keep
it as collateral
with the Federal reserve.
And these are called repurchased
transactions.
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.
No-one else is willing to lend
him money so the Federal funds
rate is now a non-issue.
So he goes to the discount
window and borrows directly
from the Federal reserve as
a lender of last resort.
And the rate at which he
borrows-- the interest that he
pays this guy, that is
the discount rate.
So that's the rate that a bank
pays to the Federal reserve
when it can't borrow from
another bank overnight.
And in general, the discount
rate tends to be higher than
the Federal funds rate.
In fact, it always is, right?
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.
But we'll see in future videos,
when times get tough,
this gets used a lot more.
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, 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.
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.
This is for lending
of last resort.
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.
Anyway, see you in
the next video.