🙋 Student Q&A (Lecture 4)

Click here to learn about timestamps and my process for answering questions. Section agendas can be found here. Email office hour questions to rob.mgmte2000@gmail.com . PS1Q2=“Question 2 of Problem Set 1”

📅 Questions covered Saturday, Feb 22

🕣 3:11pm
❔ This morning there was an interesting interview on NPR with the president of the Chicago Fed. https://www.npr.org/2025/02/22/nx-s1-5305109/new-data-shows-consumer-sentiment-about-the-economy-is-down

✔

📅 Questions covered Tuesday, Feb 25

🕣 7:48pm
❔ How do we tell whether it is expansionary or contractionary

✔ Intuitively, expansionary means that interest rates are falling. Contractionary means that interest rates are rising.

The target interest rate that we refer to is the Fed Funds rate, which is the average interest rate that banks charge each other when they lend money to each other. The Fed controls this interest rate via IORB and Discount window (ample reserves) or OMO (limited reserves).

An alternative definition of expansionary vs contractionary is that expansionary expands the money supply and contractionary decreases the money supply. In other words if ΔMS>0 its expansionary and ΔMS<0, it’s contractionary.

Notably, expansionary monetary policy also “expands the economy.” Contractionary monetary policy “contracts the economy.” In other words, expansionary causes GDP to be larger and contractionary causes it to be smaller.

🕣 around 7:55pm
❔ Are banks required to lend and borrow money at the Fed Funds rate.

✔ NO.

Then Fed has no legal power to tell the banks at which interest rate they can lend or borrow money. The Fed can’t tell banks what interest rates to use in the US.

It can only affect the Fed Funds rate by doing OMOs, or by changing its administrated rates (IORB and Discount Rate). Note that the administrated rates are rates at with the Fed either lends or borrows money.

Basically, all that the Fed can do is:

1. change the rates at which it is willing to lend (Discount Rate) or borrow money (IORB).
2. buy or sell securities.

You may ask, “how the heck do these two things change the Fed Funds rate?”

The main point of lecture 4 was providing an answer to that important question.

🕣 8:46pm
❔Based on your session on Saturday and the notes I am struggling to understand how in 3b none of the transactions affect Total Reserves.

Maybe you can dive deeper into the difference in the value cash versus deposits in the central bank. I understand that the vault cash is cash int he bank but we do not have any examples with the reserves broken into the two categories.

✔ In 3b, vault cash can’t change, but deposits at the Fed can change. If any of the transactions change Total Reserves, just have them change deposits at the Fed.

In other words, there is nothing in 3b that says that none of the transactions affect Total Reserves.

Reserves definitely change in this question. See the solution recording for more details.

🕣 8:47pm
❔Just a question on Lecture 4, I do not fully understand how arbitrage works, I see how banks can take advantage if the FFR is under the IORB or over the Discount rate, but what is stopping banks from keeping the FFR under the IORB or over the Discount rate and continuing to make free money? The Fed does not control the FFR as far as I remember, so I’m a bit confused on this.

✔ We talked earlier about how the demand curve has two curved areas. Regarding the IORB, arbitrage just says that demand for reserves goes to ∞ when the fed funds rate approaches the IORB. When this happens, supply and demand ensures that the FFR can’t be less than IORB.

Intuitively, as we said earlier, no bank will lend money for less than the IORB because they could simply deposit the money at the fed and earn the IORB.

Likewise, no bank will pay a FFR more than the discount rate to get new funds. No bank wants to overpay on any interest rate.

🕣 8:50pm
❔I am a bit confused on the following and need your help to understand the following:

Professor Watson mentioned that “When the Feds lower that interest rate on reserve balances then the banks can lower the rates they charge on their riskier loans e.g mtg loans, auto loans etc.

When Feds raises interest rates on reserve balances than banks will raise rates they charge on all their riskier loans”.

I thought the Banks charge higher rates on riskier loans and lower rates on secured loans ?

✔ That’s a great question. The short answer is that it is true that banks always charge higher rates on riskier loans and lower rates on secured loans. However, the rates on riskier loans sometimes rise and sometimes fall. Likewise, the rates that they charge on secured loans sometimes rise and sometimes fall. Basically, all different categories of interest rates are constantly changing.

What Bruce is saying there is that when the Fed lowers interest rates on reserve balances, then all sorts of other interest rates tend to fall.

Likewise, when the Fed raises interest rates on reserve balances, then all sorts of other interest rates tend to rise.

🕣 8:51ish pm
❔ What are the “certain types of deposits and other liabilities” the Feds are referring to in the 3rd paragraph ?
https://www.federalreserve.gov/monetarypolicy/reservereq.htm

✔ Generally, this applies to “demand deposits,” which are conventionally known as checking deposits. Reserve requirements apply to checking deposits.

🕣 8:52pm
❔ The banks are holding approximately $ 3 Trillion worth of Reserves. Wouldn’t the U.S. economy become much more stronger and robust if the Banks just lent out money which would have a cumulative effect on the economy. If the Banks are worried about loan defaults couldn’t they get Loan Insurance?

✔ Yes, the banks don’t lend the money out because they don’t think it would be profitable.

Generally, you can’t get insurance for less than it would cost to provide the insurance. Someone would have to take the loss, so the premiums on the insurance would be extremely high. Generally, a bank can’t give a loan that it would lose money on. Essentially, they’ve already given loans to everyone they can profitably lend to.

🕣 8:54pm
❔To clarify - whenever the Fed reduces interest rates then we are in an Expansionary Monetary Policy which combats inflation?

✔ Close. Lowering interest rates is expansionary, but it causes inflation rather than combatting it.

🕣 8:55pm
❔ I wonder if you could clarify this for me:
In the book, page 243, it says: Fed imposes regulations, called reserve requirement, making it obligatory for banking institutions to keep a certain fraction of their deposits as reserves with the Fed. This sentence is consistent with what I understand from the lectures, if required reserve ratio is 10%, they need to keep 10% with the Fed; i.e. the deposits in the Central bank. But, I see that you and Harry does not interpret it like that; i.e. in your answers it does not need to be with the Fed (in other words it does not need to be with the Central Bank, it can be in cash vaults also). Am I interpreting something wrong when the book says “reserves with the Fed”?

✔ In this course, it doesn’t need to be with the fed. Any sort of reserves count toward reserve requirements.