Banking 16: Why target rates vs. money supply발음듣기
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Banking 16: Why target rates vs. money supply
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In the last couple of videos, we've gone over the idea that the Federal Reserve manages the money supply by setting a target interest rate.발음듣기
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And there might have been the obvious question circling in your brain - why don't they just manage the money supply by instead of setting a target interest rate, why don't they set a target money supply?발음듣기
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$900 billion and they just - if it's at $800 billion now, they just print that much - $100 billion dollars more of base money or Federal Reserve deposits or Federal Reserve notes and then the M0 will get to $900 billion and then you'll have the multiplier effect and more lending will take place and then you will increase the M1.발음듣기
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They could say we want the M1, which is the M0 plus checking deposit accounts - so essentially, anything that can be used for money.발음듣기
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So actual cash, reserve deposits, or checking accounts can be used for money because you can write checks against them.발음듣기
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Maybe one thing they could do, they could say, our goal is for M2 to always be - 50% of GDP, right?발음듣기
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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, then it'll have a multiplier effect and we'll just keep measuring it.발음듣기
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If it goes a little bit above, we'll do some open market operations and sell our treasuries and take reserves out of the banking system.발음듣기
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So that's a completely legitimate way of thinking about it - and actually, there are some people who do advocate it this way.발음듣기
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And there is no clear answer to why they're doing this, but I've thought about a little bit and there's two reasons that I can think of why this might make more sense - although there's a part of me - and maybe in a future video, I'll make an argument for why actually doing something like managing the money supply to 50% of GDP might actually make a little bit more sense.발음듣기
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The first reason is kind of one out of convenience - that the short term interest rate with which banks lend to each other is just easier to measure than any of these money supply things.발음듣기
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If I'm Ben 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.발음듣기
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While if you were targeting actual money supply you would have to tabulate these fairly quickly if you wanted real time information and that would just be more of a mess.발음듣기
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To actually calculate the M2, you'd have to survey the banks and maybe you could do it with some IT systems, but you're not going to get that real time information - or at least it would be harder to.발음듣기
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The other reason - and this is a little bit more abstract, but I think it'll make sense to you.발음듣기
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And let's say there's a couple of farm projects where farmers need to borrow money to buy seeds.발음듣기
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One of them returns a - the farmer will proceed if he can get lending at 20% or lower interest rates.발음듣기
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So if someone's willing to lend him money at 21% interest rate, he'll be like, no, that's way too much.발음듣기
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But if he can get money at 19%, he's like, OK, I'll borrow the money and I'll buy the seeds because it will create so much value that I'll easily be able to pay back that interest.발음듣기
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He's got a really good idea, a new technology he wants to invest in and he's going to move forward building the factory if he can get - I don't know - 19% funding.발음듣기
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So essentially the money is going to be lent to the people willing to pay the highest interest rate.발음듣기
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So in this case - for the sake of simplicity, we're assuming all these are kind of the same amount of money, just not to make things too complicated.발음듣기
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And essentially they're going to pay the highest interest rate that the worst among them is willing to pay.발음듣기
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I'm making a lot of simplifying assumptions, but I really just want you to get the underlying idea.발음듣기
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And you might say, well, it's good that society didn't allocate money to this guy and this guy because these were shady projects to begin with, but it's kind of unfortunate.발음듣기
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This was a 12% yield project that if somehow the capital was there, we would've gotten a 12% return on society, which is - in the big picture of things, a really good project, but there just wasn't enough capital at that moment in time.발음듣기
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But let's say the money supply stays constant - or at least in the medium term over the course of a year because that's what the Fed is targeting.발음듣기
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And let's say this guy got done, but let's say there's another project just like it that's 19%.발음듣기
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And all of a sudden, since the planting season's done, none of the farmers want money anymore, but if you're keeping the money supply constant, now which projects are going to get done?발음듣기
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Well, this good project here is going to get done, but so are these two kind of crappy projects.발음듣기
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So you have a situation here where the money supply did not - it wasn't elastic with the demand and the negative side effect to society in this situation is, when people needed money, we were passing on good projects that really should have been done because these were really safe projects.발음듣기
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And then later, when the timing is bad and we keep the money supply constant, bad projects will get funded because there's just so much money to go around and none of these people need to use it that these really crappy projects that might even be negative - remember, these are what the investor thinks they're going to get, but maybe there's a lot of risk and these end up - if the investor thinks they're going to get a 1% return, maybe they made a mistake.발음듣기
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So this is the problem where over a medium period of time, if you hold the money supply constant, you'll be passing up on good projects when there's a lot of demand for them.발음듣기
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Now, if you were managing the money supply to an interest rate - and remember, the interest rate - the federal funds rate, is the rate that banks lend to each other, right?발음듣기
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But as we saw, when you inject reserves into the banking system, it lowers the rate that reserves are lent to each other, but also increases the lending capacity of banks.발음듣기
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And so when you increase the money supply overall the lending capacity, you're also lowering the rate at which banks lend to projects, right?발음듣기
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So more money chasing the same number of projects - the cost of lending is going to go down, right?발음듣기
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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 turns into bank lending to real projects at - I don't know - 8%.발음듣기
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Maybe we'll contract the money supply in order to keep interest rate - and of course, this isn't what they manage it to.발음듣기
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So once the planting season is over and some of these projects aren't really available as projects - these 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 flush with cash that they're chasing bad projects.발음듣기
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So that's the underlying rationale, at least from my point of view, why it makes sense to manage to an interest rate as opposed to a money supply.발음듣기
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It allows the money supply to expand and contract naturally in real time according to market demands for cash.발음듣기
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And by setting the interest rates, you're essentially setting the threshold over which you're willing to let projects only that meet that threshold get funded - and not products below it that might somehow waste money.발음듣기
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Anyway, we'll discuss this a lot more in a lot of different videos and hit it from different angles, but I just wanted to answer those questions, just so you know this wasn't some convoluted crazy thing that they're doing, although it is a little bit convoluted.발음듣기
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