hey internet this is jacob clifford and welcome to my youtube channel you've definitely seen the behind the scenes images that prove that life is not always what it seems it turns out that deception misinformation or all-out lies are all around us including i might add in your econ textbook in a previous video about monetary policy i explained how the central bank can control the money supply to increase or decrease interest rates and in that video i use this the central bank has three tools it can change the reserve requirement the discount rate or it can use open market operations now those are in every single textbook but in real life it's not that simple for example in an economics course you use the money multiplier to calculate changes in the money supply based on the reserve requirement but the united states how much is that reserve requirement how much do banks have to hold in reserves are you ready for this the answer is zero nada they don't have to hold anything so a bank can take a 100 deposit loan all of it out to another customer and when that money makes its way back to that bank they can loan it out all again and that effectively makes the money multiplier infinite my life is a lie my life is a lie okay before you freak out all the concepts you've learned the money market graph fractional reserve banking the idea of the money multiplier all those concepts are going to be on your exam because they help explain the economy just not the current united states economy the banking system before the 2008 financial crisis looked different than it does today back then commercial banks held very few reserves with the central bank and instead loaned that money to customers or to other banks this is a banking system with limited reserves and it's the one that you see in your textbook since commercial banks had very few excess reserves a small change in the money supply had a noticeable effect on interest rates in other words when the central bank bought bonds from commercial banks that money would be loaned out quickly and it would increase the money supply and decrease interest rates that's textbook monetary policy but after 2008 commercial banks held a ton of reserves with the central bank in addition to stricter regulations one of the reasons is because the fed started paying interest on those reserves so now commercial banks can deposit their extra money with the federal reserve and earn an easy safe let's say two percent and that rate is called the interest on reserves balance rate it's the amount that the fed pays commercial banks this is a banking system with ample reserves and it's the new stuff that's probably not in your textbook but you need to know it for your exam and it's definitely on the ap test before 2008 there were limited reserves in the banking system after 2008 ample reserves and with these concepts comes a new graph it explains limited and ample reserves and explains why the three tools of monetary policy that you learned aren't used in the united states today but keep in mind this is a different graph from the money market or the loanable funds market that you still need to draw and analyze instead this is the market for reserves down here we have the quantity of reserves that are deposited with the central bank and up here we have the policy rate the rate that the central bank looks at when it's conducting monetary policy in the united states that policy rate or target rate is the federal funds rate it's the rate that banks charge each other for overnight loans so since we're talking about the united states and the federal reserve let's change this from policy rate to the federal funds rate let's start with demand there's an inverse relationship between the federal funds rate and the quantity of reserves demanded if the federal funds rate is high then commercial banks don't want to deposit money with the fed they want to loan that money out to other banks and earn a higher rate of return but if the federal funds rate is low and banks can't earn that much money from lending to each other they might as well deposit that money with the fed the point is there's a downward sloping demand curve for reserves now this graph suggests that banks can borrow and lend to each other at a seven percent federal funds rate but there's another option if a bank really needs money they can borrow from the central bank the fed at the discount rate so if the discount rate was let's say five percent then banks wouldn't borrow from each other at seven percent that effectively puts a cap on the federal funds rate at the discount rate i'll explain that again if you're a commercial bank no one's gonna pay you seven percent if they can go borrow from the fed at five percent so that causes the demand to look like this [Music] so now we have the demand and the supply of reserves is vertical because it's set by the central bank those come together and give you the equilibrium federal funds rate now here's the important part when the supply is over here that shows you a banking system with limited reserves an increase or decrease in the money supply would increase or decrease reserves and that would change the federal funds rate affecting interest rates in the overall economy that's textbook monetary policy but what about a banking system with ample reserves this demand curve suggests that down here at one percent banks are willing to lend to each other but don't forget there's another option what if the fed is willing to pay commercial banks two percent for reserves remember that rate is the interest on reserve's balance rate if you're a commercial bank and the fed's willing to give you two percent then you shouldn't lend any other bank for only one percent and that's why the interest on reserves acts as a floor for the federal funds rate so the demand curve doesn't continue downward it flattens out somewhere around the interest on reserve's balance rate now here's the important part if the supply of reserves is out here and we have ample reserves in the banking system then monetary policy and those three traditional ways to change the money supply doesn't really affect interest rates think of it this way if commercial banks already have trillions of dollars deposited with the fed then an increase of only a billion dollars in the money supply is not really going to have a big effect on interest rates banks aren't going to go rush out to lend that money so the tools of monetary policy that work in a limited reserve system don't really work here in an ample reserve system okay so if those traditional tools of monetary policy don't work how does the federal reserve do monetary policy today what tool do they use well you already know they can change the interest on reserves for example let's say we have ample reserves and the federal funds rate is at two percent if the central bank wants to lower interest rates to stimulate the economy they can decrease the interest on reserves that would lower interest rates increase investment increase aggregate demand that's expansionary monetary policy and if the federal reserve want to slow down the economy they could increase interest on reserves that would increase the federal funds rate and interest rates across the board that would decrease investment in consumer spending and decrease aggregate demand that is contractionary monetary policy and it's exactly what the fed is doing right now to fight inflation they're increasing interest on reserves okay so let's summarize if there are limited reserves the central bank will use one of the three tools of monetary policy usually open market operations but when there's ample reserves those three tools don't really work so instead the fed changes interest on reserves but don't go anywhere there's still two things we have to do first i'm gonna put this back up on my wall it gives you the three tools of monetary policy the reserve requirement discount rate and open market operations those are all in your textbook you also need to know about the tools the fed uses when there's ample reserves that's interest on reserves and the second thing we have to do it's time for a pop quiz no no no no no no at the end of these videos i give you a few multiple choice questions to make sure you're getting it and the answers are in the first comment below i also added all these new concepts to my ultimate review packet and made brand new worksheets for you teachers there's samples of all those just follow the link in the description below thanks for watching until next time [Music] you