Zaks Investment Advisory Service

Money, Interest Rates, and Federal Reserve (part I)

In our previous programs, we talked about interest rates. We mentioned how these rates, i.e. the price of borrowing, are determined by the market just like the other prices in a market economy. If there is a lot of a certain product on the market, its price usually drops. If there is little of it and this product is needed, then its price goes up. In our case, the product is money and its price is the interest rate. It should be intuitively evident that the more money there is in the economy, the lower the interest rates should be. But you might say: “But what about the Federal Reserve, our central bank? Doesn’t it control the interest rates? We heard that it does.” In order to figure out the Federal Reserve’s role and abilities, we will have to first get a little sidetracked and talk about money and how banks work.

For starters, what is money? This is not as simple a question as might seem at first glance.

If you ask the first passerby what money is, they will probably tell you that money is something you use to buy things. But economists thought it over, and decided that money has three functions: it is a form of exchange (for example, you give me a pound of apples and I give you a dollar); it is a unit of accounting (for example, this house is worth 500,000 dollars); and it is a way of storing valuables (for example, I have 20 dollars in my wallet). Twenty dollars are always a good thing – but in practice, money is not just cash, or those dollar bills you keep in your wallet. Money is also your checking accounts in the bank, i.e. those accounts from which you are able to write your checks. Together, cash and checking accounts make up what economists call M1, the narrowest definition of money.

Now let us take a look at what happens to the money sitting in your bank account. This money represents an earning opportunity for a bank by way of lending: i.e. the bank takes “your” money and gives to someone else at interest. How can the bank get away with this? It happens because the bank knows through experience that it is unlikely that all of its customers will decide to withdraw all their money at the same time: banks know the approximate amount they have to keep in reserve. They put the rest of the money “to work,” i.e. on loan: that is how banks make money. Of course, lending is accompanied by certain risk: what happens if the customer goes broke and is unable to repay the bank? After all, this could result in the bank’s own bankruptcy, should it fail to return all of its customers’ money. These things really did happen at the start of the 20^th century and during the Great Depression in the United States, and in Russia in the 1990s (but for different reasons). They no longer happen now thanks to certain rules set by the Federal Reserve, our central bank. The Federal Reserves oversees the banking system’s integrity: in order to avert excesses, it requires all banks to keep a part of their money in Federal Reserve accounts – just in case, so that banks are not jeopardizing too large a part of their reserves. The size of the reserves that banks must keep at the central bank is directly dependent on the amount of money in the banks’ own deposit (checking) accounts. These reserves are called federal funds. And they play a role in how banks create money.

It really is true: banks have an amazing ability to create money! How do they do it? Imagine that you deposited $1,000 in a bank. Suppose that a part of this money, say 20 percent, or $200, must stay in the reserve of a central bank account. But the bank will be able to lend out the remaining $800 of your money at interest to another customer. Imagine that the bank did just that, and this client took the $800 and put them in a personal checking account at a second bank. The second bank ended up with $800, $160 of which it must keep in reserve and the remaining $640 of which it can lend. The customer who took the $640 also placed them in an account. As a result of these transactions, our initial $1,000 turned into $1,000 plus $800 plus $640, i.e. into $2.440! And all of this is real money. Please note that the amount of money being created in the system depends on how much the central bank says must be kept in its accounts: if for every $1,000, the central bank had set the limit at only $100, then banks would have created even more money. The bank could have then taken your $1,000 and loaned out $900 instead of $800, and so on. Even more money would have been created in the system as a result.

Now imagine that a certain bank somehow ended up with extra money in its reserve account – extra in a sense that it exceeds the minimum amount required by the central bank. This means that the bank has, so to speak, “extra” money that it could lend without breaking Federal Reserve rules. What will this bank do? Banks, just like all other “normal” companies, try to maximize their returns. As we know, banks’ returns are earned through lending. It is absolutely clear that a bank will jump at the first chance to issue an extra loan. As soon as a bank issues a new loan, the amount of money in the system grows.

So, it turns out that the Federal Reserve (central bank) may regulate the amount of money in the banking system (and, accordingly, in the economy as a whole) by regulating the size of the reserves that banks must keep with the Federal Reserve. Next time, we will take a look at how exactly the central bank increases or reduces this amount, how this affects interest rates – and which particular interest rates and, indirectly, our investments.

With this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.