Ample reserves regime | AP Macroeconomics | Khan Academy

- [Instructor] What we're
gonna do in this video

is talk about some interesting things

that have happened since
2008, and in particular,

we're gonna talk about what
an ample reserves regime is,

but even more importantly, what
its actual implications are

and how you can analyze
it with a graph like this.

So let's just make sure we
have our bearings first.

So the horizontal axis right
over here is reserve balances,

and then the vertical axis
here is interest rates.

So for the first part of this discussion,

let's ignore everything that
we see in gray over here.

That's what we're gonna talk about

when we talk about the
ample reserves regimes.

Let's say we're talking
about a period pre-2008.

And in that situation,

you could imagine the more
reserve balances you have,

the lower the demand is
for reserve balances,

because if more banks
are sitting on reserves,

well, then they don't
need to go into the market

and borrow reserves as much.

And so what you would naturally expect

is as reserve balances
increase, demand goes down

and of course, the actual interest

that people would need to
pay in order to get reserves

if they're running low would go down.

So, for example, let's
ignore this red line here.

Let's imagine a pre-2008 scenario
where the actual reserves,

the supply of reserves looks like this.

And of course, the Federal
Reserve can determine this

by printing money,
increasing its balance sheet

or contracting its balance sheet.

They can do that as they see fit.

So in this situation right over here,

these are the total reserves
that are in the system

that the Federal Reserve can decide.

And you have now a market
rate for overnight reserves.

So if a bank is running low,

let's say they had a lot of withdrawals,

they need to meet their
reserve requirements back then,

well, then they would go
into the, quote, money market

and they would borrow some
of that money from a bank

that has excess reserves.

Now, you might be wondering,

why does this curve, this
blue curve flatten out

as you go further and further to the left?

Why doesn't it do something like this?

If the reserve balances are
lower, and lower, lower,

you'd think people would charge higher

and higher interest rates
to land reserves overnight.

Well, what puts a cap on
this is the discount window.

This primary credit rate, this is the rate

that a bank in good
standing, a strong bank,

you also have a secondary credit rate

for slightly weaker bank,
that would be a higher rate,

but this is essentially

what banks can go to the Federal Reserve

and borrow directly
from the Federal Reserve

at the discount window.

So that discount window
rate right over here,

that essentially puts a cap on
the overnight borrowing rate,

a cap on the rate that
a bank would have to pay

in order to borrow reserves.

And so that's why you see the curve

essentially gets limited by that.

But now let's think about
what happened in 2008,

and to understand that,
I always get a kick

out of looking at the total
assets of the Federal Reserve.

This is essentially the Federal
Reserve's balance sheet.

You can view this as how much base money

they have put into circulation.

And I know these numbers are hard to read,

so let me write it down for you.

Out here, that is 2008, 2008.

And the rightmost point,

we are about three fourths of the way

through 2023 over here.

Now, you see something
interesting happening

essentially a little
bit midway through 2008.

The balance sheet increases significantly.

We go from roughly 1
trillion of base money

to $2 trillion of base money.

So essentially what the
Federal Reserve was doing,

they were taking this vertical line

and they were pushing it
far to the right over here.

Now, you might think historically
why were they doing that.

Well, some of you might
remember, we had banks failing.

It had a financial crisis.

They wanted to shore up not
just the banking system,

but also the economy.

So the Federal Reserve just
started printing money,

and it put us into a new territory,

a territory of ample reserves.

That's why it's called
an ample reserves regime.

Now, there's an interesting
question, though.

If you go to a situation
of ample reserves,

and that's essentially the situation

that we could imagine right over here,

well, if you just had your
traditional demand curve here,

this curve would've just kept
going down and down and down.

And essentially there's so
much reserves in the system

that the demand would go so low

that if a bank had access reserves,

it would pretty much get
little to no interest

on those reserves.

Now, that's a tough
situation in and of itself

because some of those banks
needed that interest on reserves

because, once again, they
were all in a tough situation.

And also, you want a situation

where banks could probably
attract some depositors

by hopefully giving some interest

to the depositors themselves.

That also would strengthen
the banking system.

So that's when in this
ample reserves regime,

the Federal Reserve did something else.

They said, "Okay, banks,
it is no longer the case

that the only way that
you could get interest

on your reserves is by
lending it to other banks.

We're going to allow you
to take those reserves

and deposit them with us,
with the Federal Reserve,

and we will give you
interest on those reserves."

That's what this IOR is,
interest on reserves.

And so if you are a banking institution,

this essentially set up
a floor on the interest

that you would get on your reserves.

Now, the question you
might be wondering is,

why doesn't this blue line then

just flatten out right over there?

And in some more simplified diagrams,

you will actually see that.

But it turns out that banks
are not the only participants

in the money market.

You have other people

who are potentially
lending reserves to banks,

and they don't have access

to depositing their reserves
with the Federal Reserve.

So that's not a floor on them.

The Federal Reserve
introduced another rate.

I won't go into the details
of what on RRP stands for.

These essentially repurchase agreements.

This is essentially the
Federal Reserve giving interest

to non-banking institutions
on reserves that they place

with the actual Federal Reserve.

So this places a hard floor,
'cause even those folks,

they would never wanna lend below this

because they could get that much interest

with the Federal Reserve.

Now, the next question
you might be wondering is,

all right, if we are out here
in this ample reserves regime,

traditionally the Federal
Reserve could change

the federal funds rate, the target rate

by moving this red line
to the left and the right.

If you're in a non-ample reserves regime,

if you move this red line to the left,

well, what's gonna happen?

You're going to essentially increase

the overnight borrowing rate,

and that would constrict the economy.

And if you move it to the right,

you're going to decrease the
overnight borrowing rate,

and that would stimulate the economy.

If you're out here on the right side,

if you move this vertical red
line to the right or the left,

it's not going to change
the overnight borrowing rate

because you're essentially
going to be hugging

this pretty flat blue line.

And things have gotten
even more ample since 2008.

We went from roughly 1
trillion to 2 trillion,

and then out here we are getting,
approaching 8, 9 trillion.

And you might say, "Well, what
happened right over here?"

Well, that was the COVID
pandemic, where, once again,

the Federal Reserve really
wanted to stimulate the economy,

and they did that by
printing a ton of money.

So in the scenario that we've
been in for a while now,

we are deep into an ample reserves regime.

If we were in ample reserves in 2008,

we're that much further
right now in the 2020s.

So how does the Federal Reserve

actually control interest rates now?

Well, what they can do is
they can control these floors,

or you could say this
floor right over here.

If they want to increase interest rates,

they just increase the
interest on reserves they give.

And if they do that,

then the curve will look
something like this,

and then the overnight
borrowing rate will be higher,

and then, of course,
that would be restrictive

for the economy, and if they wanna loosen,

they can likewise lower
the interest on reserves.