Learn about Banking 16: Why target rates vs. money supply Video

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Learn about Banking 16: Why target rates vs. money supply

Learn about Banking 16: Why target rates vs. money supply In the last couple of videos we’ve gone over the idea that the a federal reserved men uses the money supply by setting a target interest rate and here might have been the obvious question circling in your brain, what don’t they just manage the money supply by set a setting a target interest rate? Why don’t the set a target money supply? They could say that “We want the M0 to be.” They could say, “We have a target M0 of $900 billion and they just―” If it’s set $800 billion now they just print that much a $100 billion or more of base money or federal reserve deposit or federal reserve notes. And then the M0 get to $900 billion and then you’ll have the multiplier effect and more lending will take place and then you’ll increase the M1. So, similarly they could have a target M1, they could say “We want the M1” which is the M0 plus checking the deposit account. So, essentially anything that can be used for money, so, actual cash reserve deposits or checking accounts can be used for money because you can write checks against them. So they could say, “We allot that target to be to $2 trillion.” They could say, “We’re targeting the M2.” M2 is the M0, will the M1 plus savings account and money market accounts so they could say “We’re targeting that to be $8 trillion” and as you know I actually look up this numbers as of at least o5 o6 this numbers weren’t that far off, the M0 was more $8 hundred billion but just you can get an idea these are real number. So, the obvious question is why don’t they do that? Why don’t they just grow the money supply? Maybe they say one thing they could do, and they could say “Our goal is M2 to always be 50% of GDP.” They could say, “Let’s make it always 50% of GDP”. So, as the economy grows we just have to make sure that if it falls below 50% of GDP that we just have to print a little bit more money and then will have multiplier effect and we’ll just measuring it. If it goes a little above will do some open market operation and sell our treasurers and take reserves out of the banking system. So, that’s a completely legitimate way of thinking about it and actually there are some people who do advocate it this and there is no clear answer to why did they doing this but I thought about it a little bit and there is two reason that I can think of why this might more sense although there is part of me and maybe in the future video I’ll make an argument fro why you – this actually doing something like managing the money supply the 50% of GDP might actually make a little bit more sense. But anyway, the first reason is kind of one out of convenience that the short term interest rate which bank let to each other is just easier to measure than any of this money supply things. If I’m Dean Bernanke and I want to know what banks are lending to each other at, I could just sample the market at that moment in time, I could say “I’m a banker, what are you willing to lend to me?” and he’ll say “oh, 5.2% “and I like “oh, that’s a little bit above our target we have to buy more treasuries”. So, you can get a very real time notion of where the market is minute by minute. You don’t have to wait for some surveys to get completed or anything like that. While, if you were targeting actual money supply you would have to tabulate this fairly quickly if you wanted a real time information and that would just be more of a mass, actually calculate the M2 you don’t have to survey the banks and maybe you could some IT systems but you’re not going to get that real time information at least it would be harder to you. And the other reason, and this is a little bit more abstract but I think it’ll make sense top you. Let’s say it’s the autumn, no, no, let’s say it’s the planting season, I never been a farmer but I think the planting season some time in the spring, and let’s say there is a couple of farm projects where farmers needed to borrow money to buy seeds. One of them returns a, the farmer will proceed if he can get lending at 20% or lower interest rates. So, if someone is willing to lend him at 21% interest rate he’ll be like no that’s way to much but if you can get money at 19% interest rate he’s like “okay, I’ll barrow the money and I’ll buy the seeds because it will create so much value that I’ll easily be all to pay that in that interest”. Say there is another farmer with an 18% project, so if he gets 18% or lower interest rate he’ll proceed with his project. And let’s say there is another farmer with, let’s say its 12% project, if he gets funding at 11% he’ll move forward and he’ll buy the seeds and he’ll plant them. And, let’s say there’s a couple of other projects in this universe let’s say there is factory guy, he got a really good idea, new technology he wants to invest in and he’s going to move forward building the factory I he can get 19% funding. 19% and let’s say there is another guy, another factory guy who would get, I don’t let me make it, who would get 3% funding, so he’s not too confident about his project, he thinks that this project only make sense to move forward if he can get 3% to a better funding so when I say better less than 3% -- my phone is ringing but I’ll ignore it because I’m on a role – and there is another guy who is really marginal, really shitty, he got a really shitty project, he himself is not too confident in it. He will only proceed with this project if he essentially gets money for free. So this is the state of affairs in the spring or during the planting season and these are the, so all of this would be potential consumers of money. And let’s say that this is money supply, lets’ say the money supply is fixed at that moment in time. So, -- I’ll draw the money supplies circles, so there’s three circles of money. So, essentially the money is going to be lent to the people willing to pay the highest interest rate. So, in this case, unless you don’t know, for the sake of simplicity, all of these are kind of the same amount of money just not to make things too complicated. So, in a capital of system, the three best projects would get the money and so it will be which ones, it’ll be this one, this one and this one; these three guys will get the money. And essentially they were going to pay the lowest interest rate. They are going to pay the highest interest of the worst among them is willing to pay. So, this money is going to these three guys at essentially at 17.9% interest. 17.9% interest is going to be lent to these three guys. And I’m making a lot of simplifying assumption but I really just want to get the under lying idea. And these projects these three projects are not going to get done and you could be might say “will, it’s good, that’s society didn’t allocate money to t his guy and this guy because there were shitty projects to begin with” that’s kind of unfortunate, this was a 12% yield project tat if some have a capital was there we’re gong to look at 12% returns as on the society which is the big picture o things of really good project but there’s just wasn’t enough capital at that capital at that moment in time. There was no enough money at that moment in time to support this project, fair enough. But, let’s say the money supply stays constant or at least in the medium term or the course of the year because what a fed is targeting. So, as we get away from the planting season, this project disappear, this project disappear, there no longer there because the planting is isn’t there anymore. And, this guy got done but let’s say there is another project just like it, that’s 19% and all of a sudden since the planting seasons is done none of the farmer want money anymore but if you’re keeping the money supply consent, no, which project are going to get in. will these group project here is going to get done. But so are these two kind a crappy project and they’re going to be lent at a much lower rate, the average rate that gets let to is going to be one or 2% or something really low. So, what you have at the situation here is that the money supply did not, it was elastic with the demand and the negative side effect to society in this situation is when people needed we were passing on good projects tat really should’ve been done because these were really safe projects. And then later when kind of a timing is bad and we keep the money supply constant, bad project will get funded because there just so much money to go around and none of this people need to use that this really crappy projects that might been a negative, I mean remember, these are what the investors things they are going to get but maybe there is a lot of risk and this can end up. If the investors thinks are going to get 1% return maybe they made a mistake, maybe they’ll get a minus 5% return and incase we are going to be destroying wealth. So, this is the problem where over medium period of time if you hold the money supply constant you’re not able to, you’ll be passing up good, you’ll be passing up on good projects when there is a lot of demand for them and then you’ll be investing in bad projects when there is not much demand for projects. On the other hand, if you have at least to the same scenario over again – I think I may that a little missy – lets’ say you have a couple of farmers again, will draw a line here, so, you have the 20%, 18%, 12% and then you had the – I’ll draw them al in yellow – then you had the 19%, 3% and 1%. Now, if you were managing the money the supply to an interest rate and remember, the interest rate, the federals rate is that rate that bank lent to each other. But as we see when you inject reserves into the banking system, it lowers the rate that reserves a lent to each other but also increases the lending capacity of banks. So it would increases the money supply and so when you increase the money supply over all the lending capacity you’re also lowering the rates at which banks lent to projects. You are increasing the amount of money maybe the projects haven’t change that much, so more money chasing the same number of projects. The cost of lending is going to go down. So, let’s say the FED manages the interest rate in such a way that the Fed target rate was 5% but let’s say that it turns into bank lending to real projects at 8%, at 8%. So, in this case we’re not fixing the money supply, we’re just adjusting the money supply in such a way that the interest rate is fixed. So, now during the planting season which projects which projects are you going to get funded? This one, this one, this one, and this one and these get guys are not going to get funded. And then when the planting is over we’re still keeping the interest rate the same, maybe we’ll contract the money supply in order to keep interest rate. And, of course this is what they manage in, they manage to the inter bank lending but it’s all related, I just want to give a sense of why it makes more sense to manage to an interest rate. So, when the planting is over and some of these projects aren’t really available as projects what were the, this were all the planting projects. In this situation when we had a constant money supply we would lend to these crappy projects but now that we keep the interest rates constant or relatively fixed still only the good project is going to get funded. And we don’t have to worry about banks just because they’re chasing yield and they’re so flash with cash that they’re chasing bad projects. So, that’s the underline rational, it’s for my point of view why it make sense to manage with interest rate as oppose to money supply, it allows the money supply to expand and contract naturally in real time according to market demands fro cash and by setting the interest rate you’re essentially the threshold over which you’re willing let projects only that met that threshold get funded and not projects below would that might somehow waste money. Anyway, we’ll discuss this lot more in a lot of different videos and hear it from different angles but I just want to answer those questions just so you know that this wasn’t some kind a convoluted crazy thing that we are doing although it is a little bit convoluted just not that crazy. Anyway, see you in the next video.

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Learn about Banking 16: Why target rates vs. money supply

In the last couple of videos we’ve gone over the idea that the a federal reserved men uses the money supply by setting a target interest rate and here might have been the obvious question circling in your brain, what don’t they just manage the money supply by set a setting a target interest rate? Why don’t the set a target money supply? They could say that “We want the M0 to be.”

They could say, “We have a target M0 of $900 billion and they just―” If it’s set $800 billion now they just print that much a $100 billion or more of base money or federal reserve deposit or federal reserve notes. And then the M0 get to $900 billion and then you’ll have the multiplier effect and more lending will take place and then you’ll increase the M1.

So, similarly they could have a target M1, they could say “We want the M1” which is the M0 plus checking the deposit account. So, essentially anything that can be used for money, so, actual cash reserve deposits or checking accounts can be used for money because you can write checks against them.

So they could say, “We allot that target to be to $2 trillion.” They could say, “We’re targeting the M2.” M2 is the M0, will the M1 plus savings account and money market accounts so they could say “We’re targeting that to be $8 trillion” and as you know I actually look up this numbers as of at least o5 o6 this numbers weren’t that far off, the M0 was more $8 hundred billion but just you can get an idea these are real number.

So, the obvious question is why don’t they do that? Why don’t they just grow the money supply? Maybe they say one thing they could do, and they could say “Our goal is M2 to always be 50% of GDP.” They could say, “Let’s make it always 50% of GDP”.

So, as the economy grows we just have to make sure that if it falls below 50% of GDP that we just have to print a little bit more money and then will have multiplier effect and we’ll just measuring it. If it goes a little above will do some open market operation and sell our treasurers and take reserves out of the banking system.

So, that’s a completely legitimate way of thinking about it and actually there are some people who do advocate it this and there is no clear answer to why did they doing this but I thought about it a little bit and there is two reason that I can think of why this might more sense although there is part of me and maybe in the future video I’ll make an argument fro why you – this actually doing something like managing the money supply the 50% of GDP might actually make a little bit more sense.

But anyway, the first reason is kind of one out of convenience that the short term interest rate which bank let to each other is just easier to measure than any of this money supply things. If I’m Dean Bernanke and I want to know what banks are lending to each other at, I could just sample the market at that moment in time, I could say “I’m a banker, what are you willing to lend to me?” and he’ll say “oh, 5.2% “and I like “oh, that’s a little bit above our target we have to buy more treasuries”.

So, you can get a very real time notion of where the market is minute by minute. You don’t have to wait for some surveys to get completed or anything like that. While, if you were targeting actual money supply you would have to tabulate this fairly quickly if you wanted a real time information and that would just be more of a mass, actually calculate the M2 you don’t have to survey the banks and maybe you could some IT systems but you’re not going to get that real time information at least it would be harder to you.

And the other reason, and this is a little bit more abstract but I think it’ll make sense top you. Let’s say it’s the autumn, no, no, let’s say it’s the planting season, I never been a farmer but I think the planting season some time in the spring, and let’s say there is a couple of farm projects where farmers needed to borrow money to buy seeds. One of them returns a, the farmer will proceed if he can get lending at 20% or lower interest rates.

So, if someone is willing to lend him at 21% interest rate he’ll be like no that’s way to much but if you can get money at 19% interest rate he’s like “okay, I’ll barrow the money and I’ll buy the seeds because it will create so much value that I’ll easily be all to pay that in that interest”. Say there is another farmer with an 18% project, so if he gets 18% or lower interest rate he’ll proceed with his project. And let’s say there is another farmer with, let’s say its 12% project, if he gets funding at 11% he’ll move forward and he’ll buy the seeds and he’ll plant them.

And, let’s say there’s a couple of other projects in this universe let’s say there is factory guy, he got a really good idea, new technology he wants to invest in and he’s going to move forward building the factory I he can get 19% funding. 19% and let’s say there is another guy, another factory guy who would get, I don’t let me make it, who would get 3% funding, so he’s not too confident about his project, he thinks that this project only make sense to move forward if he can get 3% to a better funding so when I say better less than 3% -- my phone is ringing but I’ll ignore it because I’m on a role – and there is another guy who is really marginal, really shitty, he got a really shitty project, he himself is not too confident in it. He will only proceed with this project if he essentially gets money for free.

So this is the state of affairs in the spring or during the planting season and these are the, so all of this would be potential consumers of money. And let’s say that this is money supply, lets’ say the money supply is fixed at that moment in time. So, -- I’ll draw the money supplies circles, so there’s three circles of money.

So, essentially the money is going to be lent to the people willing to pay the highest interest rate. So, in this case, unless you don’t know, for the sake of simplicity, all of these are kind of the same amount of money just not to make things too complicated. So, in a capital of system, the three best projects would get the money and so it will be which ones, it’ll be this one, this one and this one; these three guys will get the money. And essentially they were going to pay the lowest interest rate.

They are going to pay the highest interest of the worst among them is willing to pay. So, this money is going to these three guys at essentially at 17.9% interest. 17.9% interest is going to be lent to these three guys. And I’m making a lot of simplifying assumption but I really just want to get the under lying idea.

And these projects these three projects are not going to get done and you could be might say “will, it’s good, that’s society didn’t allocate money to t his guy and this guy because there were shitty projects to begin with” that’s kind of unfortunate, this was a 12% yield project tat if some have a capital was there we’re gong to look at 12% returns as on the society which is the big picture o things of really good project but there’s just wasn’t enough capital at that capital at that moment in time. There was no enough money at that moment in time to support this project, fair enough.

But, let’s say the money supply stays constant or at least in the medium term or the course of the year because what a fed is targeting. So, as we get away from the planting season, this project disappear, this project disappear, there no longer there because the planting is isn’t there anymore.

And, this guy got done but let’s say there is another project just like it, that’s 19% and all of a sudden since the planting seasons is done none of the farmer want money anymore but if you’re keeping the money supply consent, no, which project are going to get in. will these group project here is going to get done.

But so are these two kind a crappy project and they’re going to be lent at a much lower rate, the average rate that gets let to is going to be one or 2% or something really low. So, what you have at the situation here is that the money supply did not, it was elastic with the demand and the negative side effect to society in this situation is when people needed we were passing on good projects tat really should’ve been done because these were really safe projects.

And then later when kind of a timing is bad and we keep the money supply constant, bad project will get funded because there just so much money to go around and none of this people need to use that this really crappy projects that might been a negative, I mean remember, these are what the investors things they are going to get but maybe there is a lot of risk and this can end up. If the investors thinks are going to get 1% return maybe they made a mistake, maybe they’ll get a minus 5% return and incase we are going to be destroying wealth.

So, this is the problem where over medium period of time if you hold the money supply constant you’re not able to, you’ll be passing up good, you’ll be passing up on good projects when there is a lot of demand for them and then you’ll be investing in bad projects when there is not much demand for projects.

On the other hand, if you have at least to the same scenario over again – I think I may that a little missy – lets’ say you have a couple of farmers again, will draw a line here, so, you have the 20%, 18%, 12% and then you had the – I’ll draw them al in yellow – then you had the 19%, 3% and 1%. Now, if you were managing the money the supply to an interest rate and remember, the interest rate, the federals rate is that rate that bank lent to each other.

But as we see when you inject reserves into the banking system, it lowers the rate that reserves a lent to each other but also increases the lending capacity of banks. So it would increases the money supply and so when you increase the money supply over all the lending capacity you’re also lowering the rates at which banks lent to projects. You are increasing the amount of money maybe the projects haven’t change that much, so more money chasing the same number of projects. The cost of lending is going to go down.

So, let’s say the FED manages the interest rate in such a way that the Fed target rate was 5% but let’s say that it turns into bank lending to real projects at 8%, at 8%. So, in this case we’re not fixing the money supply, we’re just adjusting the money supply in such a way that the interest rate is fixed. So, now during the planting season which projects which projects are you going to get funded?

This one, this one, this one, and this one and these get guys are not going to get funded. And then when the planting is over we’re still keeping the interest rate the same, maybe we’ll contract the money supply in order to keep interest rate. And, of course this is what they manage in, they manage to the inter bank lending but it’s all related, I just want to give a sense of why it makes more sense to manage to an interest rate.

So, when the planting is over and some of these projects aren’t really available as projects what were the, this were all the planting projects. In this situation when we had a constant money supply we would lend to these crappy projects but now that we keep the interest rates constant or relatively fixed still only the good project is going to get funded. And we don’t have to worry about banks just because they’re chasing yield and they’re so flash with cash that they’re chasing bad projects.

So, that’s the underline rational, it’s for my point of view why it make sense to manage with interest rate as oppose to money supply, it allows the money supply to expand and contract naturally in real time according to market demands fro cash and by setting the interest rate you’re essentially the threshold over which you’re willing let projects only that met that threshold get funded and not projects below would that might somehow waste money.

Anyway, we’ll discuss this lot more in a lot of different videos and hear it from different angles but I just want to answer those questions just so you know that this wasn’t some kind a convoluted crazy thing that we are doing although it is a little bit convoluted just not that crazy. Anyway, see you in the next video.

Transcription by: Scribe4you Transcription Services