The discount rate | Money, banking and central banks | Finance & Capital Markets | Khan Academy

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.

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25 thoughts on “The discount rate | Money, banking and central banks | Finance & Capital Markets | Khan Academy

  1. I still say if you lower the price of food and energy then the economic crises would disappear. I don't quite understand why we can't produce more food and lower prices for everyone so that people can have more purchasing power to buy the other things that keep the economy going. John K. Galbreath did it somewhat in WW2 but that was a price freeze.

  2. In this playlist you have been talking a lot sense except starting at 02:40 here , you think that FRN is an asset to federal reserve.
    It does not make sense. All federal reserve will do is simply create and entry in the account of the bank which sold the T-bill. refer wikipedia.

  3. LOL no longer a threat? naw u fucking wish it keep spreading day by day lmfao, and they r planning to make a vaccine they didnt even test it, it cant be used unless it is been tested, and testing need time ok? so too bad, humans r just over confidence and try to fight against nature

  4. the fed funds rate is reported to be 0; why would any bank with excess funds want to deposit their excess reserves with the feds?
    could there be a situation where a bank deposits its excess reserves with the Fed but no other banks wants to borrow?

  5. before 0ct ,2008 the overnight deopsit rate was zero and the discount rate was set below the fed funds rate; after oct 9, 2008 the federal reserve initiated interest payments at Federal Reserve Banks. This was done by Bernanke. so there are three different rates a) the discount rate where the feds lend a bank
    b) the Fed funds rate for interbank loans
    c) the overnight deposit rate

    khans videos are out of date

  6. @seven8000
    Correct, and the entire process is illegal and not authorized by the United States Constitution. Any politicians who advocated for such policy is committing tyranny and should be charged with felonies.

  7. @smokenfly514 There are several definitions. Investopedia had this to say:

    What Does Discount Rate Mean?
    1. The interest rate that an eligible depository institution is charged to borrow short-term funds directly from a Federal Reserve Bank.

    2. The interest rate used in determining the present value of future cash flows.

  8. sometimes this is stupid… when demand is low, and supply is high = price/interest is low
    but when america issue treasuries to be bought by countries. the more the demand the low the interest…

  9. Hi,
    i am studying accounting currently at college i was wondering if you could possibly do a video on settlement discounts and T accounts?

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