Banking 16: Why target rates vs. money supply

[qm1qm1]

To be honest, I didn't watch your video. What you say could be the explanation I gave. But if you need 12 minutes to describe your explanation, something's wrong with either your understanding or teaching technique.

[qm1qm1]

The reason: the broad money supply is determined endogenously. There is a clear answer

Explanation: to use the language that you learned in an undergrad course, the "multiplier" is not some fixed value, but it depends on the voluntary actions of people in the economy. In a downturn, there will be a low "multiplier", so even if banks got an significant boost in reserves, banks don't want to lend and consumers and businesses don't want to borrow, so we wouldn't get an increase in broad money.

[tangiblephoton]

ignored the phone coz he's on a roll lols....

[parenteaujason]

@tnekkc The assumption Kahn makes in that statement is that everbody acts logically, with data and statistics and margins of error and whatnot. Of course there are idiots out there who 'think' they have some great idea and would borrow at ridiculous high interest rates. Just watch an episode of "Dragon's Den" or "Shark Tank" (depending on where you're from) and you'll see all the idiots out there. Large corporations and succesful businesses generally won't make those mistakes.

[dadac123]

It made me to realize the demand and the supply again.

I always heard of demand and supply, but seldom actually use them in the reality.

But now I found that it is not the quality of something, but the demand and supply of something determined our most daily actions and decisions.

[IvanAndreevich]

And the government is supposed to know when the time for good projects is? LOOOL. Only the market knows that.

[cepson]

3 people were pissed he wouldn't answer their phone call.

[tnekkc]

Good projects are those willing to borrow at a higher rate?

I don't think so.

Kahn fail.

[asbytec]

Seems if the Fed buys treasuries, which are an obligation from the government, to the Fed (in this case), then the government owes the Fed some amount of interest. Wouldn't this situation cause the Fed to reduce it's remittances to the government? So, as the Fed expands it balance sheet, the government is actually losing money?

In context with the current crisis, as the Fed moves toxic assets (declining in value) onto it's balance sheet, the net result could be a reduction in the Fed's assets.

[MrSchirato]

I'm sorry but is a very risky thing to teach that Fed(government) is going to change the money supply to properly allocate the lending towards worthy projects! When the hell the government got the know-out to single out about good projects in the market? When not even banks at this time have a clue where the price of certain products is. Well one thing is certain that the monetary policy failed as banks didn't lend consequently each other!!

[MrPlender]

To illustrate my point:

economistsview.typepad.com/.a/­6a00d83451b33869e20120a679e1bf­970c

[MrPlender]

Sal you missed one of the most critical points on why the Federal Reserve doesn't target the money supply. The reason is not that the money supply is hard to measure for the technical reasons you mentioned but because as financial innovation has proceeded over time the boundaries between M1 and M2 have become much more fluid, making monetary aggregates impossible to define and the velocity of money erratic.

[tseelonb]

(This is the beginning of my comment).

Sal,

Not only entrepreneurs have estimations and preferences -- investors have ones too.

If an investor cannot find an investment that looks good enough for her, she will sit on her money and wait.

You can incorporate this in your drawing by specifying a minimum interest rate on each loanable fund, just as you specified a maximum interest rate on each project.

[tseelonb]

(Continued).

In a free market, loanable funds are just like any other product or service: the price (in this case, interest rate) is determined by the supply curve and a demand curve.

(Your model assumes a fixed supply of loanable funds while it should be a CURVE depending on interest rate.)

[huxtee]

@tseelonb Asset and credit markets do not act like goods and service markets which follows supply/demand optimization.

Lending money increases economic activity which in turn reduces interest rate causing even more lending. This causes a boom, opposite happens in a bust/recession.

[tseelonb]

@huxtee, you seem to be describing what happens when a central bank messes with the economy.

While I was talking about a REAL free market, where neither the interest rate nor the amount of money are controlled by a central bank.

Lending is actually not about money, it's about resources. The resources at any given point are limited. If there are too many projects being funded, there will be less resources available for additional projects, so interest rate will rise. And vice-versa.

[tseelonb]

@huxtee, another point:

When you say that lending increases "economic activity", I think "activity" is far too vague. You have to make a distinction between consumption and investment, and also between good and bad investments.

Of all the three, only good investments increase resources available for further lending, and it usually takes them time to do so.

[tseelonb]

(Continued).

Now, if an investor thinks there is a seasonal (=temporary) lack of good projects, she will NOT lend her money for a risky long-term 3% project, but instead, she will sit and wait for the next planting season.

There is no need for a central banker to step in and bridge the seasonal gaps. The market can do a better job.

[biagiolembo]

yes but maybe 19% ROI projects are chinese crappy toys and 3% ROI projects are antidesertification projetcs (very low economic return but very useful for our environment)

[8Kole8]

i too enjoy playing on paint. doesnt mean i make videos talking about gold pieces

[johnnyfenger]

Sal, your comments on elastic money supply is the main cause of the mess we are in... Please rethink your arguments... flexible money supply does not work..., Why do you want a goverment bureaucrat to decide if a 2% project should get funded or not?.. if a saver think 2% i enough... then 2% is enough.,. do not let goverment decide it,,, greenspan proved that he couldnt do it. Please read more of mises and rothbard.. i have forced to rate this video as poor, due to information in video.

[Myrkul1029]

the whole point of banks is that they invest the average person's money for the average person and take a cut for themselves. the point is the saver is not an economist and he does not realize that a project with a 2% yield is a high risk project and not economically sound, so in actually the system is stopping the guy who wants to invest in a project with 2% from making a bad economic decision. if you dont want the goverment deciding what your money should be invested in don't put it in a bank

[KLguy133]

controlling the money supply by targeting M2 etc might work if we had a truly competitive banking system.

[charlessmyth]

The negative result is that the very good £10,000 p/a wage of 1973, is now a poverty line wage, and savings, since 1973, have very little value. New lines of production are relegated to that which carries no more risk than the likes of call-centres and supermarket checkouts, since they more closely coincide with the government's demand for the market to match the model. As per Stephen King: You go out broke. But must you go out broke, at almost a decade before a working lifetime has finished.

[00dfm00]

And let's not forget that all these treasuries the Fed has bought will be due with interest. Interest the government will not have. The banks just soaked up the cash. Nobody wants to borrow it. M1 remains the same. The bankers actually take a bunch of it and put it into their personal accounts (AIG). This system requires some serious assumptions.

[00dfm00]

Another reason for not targeting M1 is that it depends on people's willingness to borrow, which isn't always there. As we can see during much of 2009, even with virtually zero rates, that isn't getting people borrowing and therefore M1 isn't increasing as expected.

[high5flyer]

Isn't fixing the money supply and floating the interest rate what Volcker did in the 80's?

[snopro54]

You need to go back and explain ROE and ROA, expected returns so this is more clear.

[dsws2]

Does money supply have to do particularly with new projects undertaken, or is that just an example? I thought it was mostly intended ordinary purchases versus money in checking accounts. An increase in checking account balances happens whenever money gets deposited into checking from a source other than another checking account. That can be a new loan, or it can be from CD, money market, etc. For individuals, isn't that mostly a matter of expectations about paychecks vs spending?

[jackuy12345]

keep them up!!!!

[sinner212121]

i dont understand why a good project would lend with higher interest than a bad project? shouldnt the bad project lend with higher interest due to its higher risk?

[dpod916]

the reason is because the person who wants to borrow the money will only be willing to borrow at a certain rate...if your project will yield a 30% return on investment then you would be willing to pay 20% in interest where as if you will only receive 5 percent return then you would not be willing to accept any rate of interest above 4 percent because then you would be either breaking even or losing money. it is the assessment of risk by the borrower not the lender in this instance.

[Corinne1231]

He was talking about the return on the projects, not on bonds. Banking's always prioritizing the safer projects, so they could get the interest plus the lending back at last.

[Roshibear]

This has been very informative, thanks for putting out this overview of the banking system. It filled in some gaps in my understanding. However, isn't this whole finanical crisis due to the FED keeping interest rates artifically low and thereby encouraging just the kind of risky, potentially wealth destorying investment that it was designed to protect us from?

[i6i85]

Sal, don't u think that when the target interest rate is consistent, instead of banks immediately 'loaning' to projects which prefer low interest (less than 4%), banks will store that money/currency and wait until spring season (when demand for loans are high) and only THEN will they proceed towards lending that money/currency to people with low interest.

[i6i85]

by the way there is a bollywood actor named salman khan in india

[michaelfresco]

The FED has an extremely difficult task to forecast the expected return on the projects undertaking by 305 million citizens.

I believe that a free banking sytem, where there is not a single planning agency (FED) to project the required M1,M2 is a much better system. The current system is doomed to fail every 4 or 5 decades.

Reference

For more Google: Econtalk Selgin on Freebanking

[michaelfresco]

test

[sgentry777]

Thanks. Extremely helpful.

In the context of the current crisis, the gov't appears to be doing contradictory things concurrently--(1) as you explain, BUYING Treasuries in the Open Market in order to 'lower FF rate' and thereby INCREASE money supply/liquidity while at same time (2) SELLING Treasuries (borrowing) in order to fund 'bailouts' , thereby DECREASING (or mopping up) liquidity. I'm confused.

[HamiDjoukou]

Yeah, I was questioning the similar thing in the previous video.

[khanacademy]

They are both actually consistent actions with increasing the money supply. As long as inflation does not become an issue and the total government debt does not become unsustainable, the Treasury could issue more and more debt which essentially gets bought by the Fed with newly printed notes. This is the Fed's last tool to fight a deflationary spiral.

[HamiDjoukou]

For me it wasnt clear that the Treasury and the Fed were two different organisations; I assumed they were the same or somehow a department of government.

[acidtrashy]

I have only understood about half of what I've seen from you. But I am better off for it. Thank you.

[jdrizd2]

Just because the expected return on an investment is low doesn't mean it is risky if it is a necessity, I believe that most supermarkets profit margin is low but they are high necessities. Other businesses are highly risky, i.e. airlines and automakers, yet can persuade banks and government to create loans. Why is there so much socialized baiilout for high risk businesses?

[khanacademy]

Those percentages aren't expected returns, they are the funding rates at which the projects would proceed. My point is that by focusing on rates, the "quality" threshold for projects stays constant. Also, low gross/operating margin at a retailer doesn't mean a low expected return on their investment (I'll eventually do a playlist on topics like that).

[khanacademy]

Just to hit the point home, let's say that you start with $.99 that you use to buy an apple which you sell for 1.00 (so .01 gross profit or 1% gross margin). You can then use the 1.00 to by another apple and repeat. If you do this 100 times in a year, you will make upwards of $1.00 (since you can reinvest the profit) on a .99 initial investment. That is a 100% return on investment despite only making a 1% margin on each transaction.

[jdrizd2]

Assuming the amount of transactions can keep up with the cost of staying in business.