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Current time:0:00Total duration:11:40

Video transcript

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 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 they could say that we want the m0 to be make sure they could say we have a target m0 of I don't know 900 billion dollars 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 so similarly they could have a target m1 they could say we want the m1 which is the M 0 plus checking the deposit account so essentially anything that can be used for money so actual cash reserve deposits or you know checking accounts can be used for money because you can write checks against them so they could say we ought we want that target to be I don't know two trillion dollars two trillion dollars they can say we're targeting the m2 m2 is the m0 well the m1 plus savings accounts and money market account so they could say we're targeting that to be eight trillion dollars and just you know I actually looked up these numbers as of at least a 506 these numbers weren't that far off the m0 was more like 800 billion but just so you get an idea these are these are real numbers 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 they could say our goal is for m2 to always be I don't know 50 percent of GDP right they could say let's make it always 50 percent of GDP so as the economy grows we just have to make sure that if it falls below 50 percent 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 if it goes a little bit above well we'll do some open market operations and sell and sell our Treasuries 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 way and I there is no clear answer to why there doing this but I thought about a little bit and there's there's two reasons that I can think of why this might make more sense although there's there's a part of me and maybe in a future video I'll make an argument for why you this actually doing something like managing the money supply to 50 percent 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 with which banks lend to each other is just easier to measure than any of these money supply things if I'm Ben Bernanke and I want to know what what what banks are lending to each other at I could I could just sample the market at that moment in time I could say oh you know I'm a bank when you're willing to lend to me at and they'll say oh five point two percent and 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 these fairly quickly if you wanted real-time information and that would just be more of a mess to actually calculate the M - you'd have to survey the banks and maybe you can do some IT systems but it's you're not going to get that real-time information or at least it would be harder to the other reason and this is a little bit more abstract but I think it'll make sense to you let's say it's it's the autumn right no no let's say it's the planting season I've never been a farmer but I think the planting season sometime in the spring and let's say there's a couple of farm projects where farm farmers need 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's willing to lend him money twenty one percent interest rate he'll be like no that's way too much but if you can get money at nineteen percent interest rate he's like okay I'll borrow the money and I'll buy the seeds because I it it will create so much value that I'll easily be able to pay that in fact that interest say there's another farmer with an 18% project so if he gets 18% or lower interest rates he'll proceed with his project and let's say there's another farmer with a let's say it's a 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 projects in this universe let's say you know there's a factory guy he's got a really good idea 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 nineteen percent funding nineteen percent funding and let's say there's another guy another factory guy who would get I don't let me make it who would get three percent funding so he's not too confident about his project he thinks that this project only makes sense to move forward if he can get three percent or better funding so when I say better less than three percent my phone is ringing but I'll ignore because I'm on a roll and there's another guy who's really marginal really [ __ ] he's got a really shady 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 and in the spring or during the planting season so and these are the kind of the so all of these would be potential consumers of money and let's say that this is the money supply let's say the money supply is fixed at that moment in time so let's say I have I'll draw the money supply circles so there's three circles of money right 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 know for sake of simplicity assuming all of these are kind of the same amount of money just not to make things too complicated so in a capitalist system the three best projects will get the money and so it'll be which ones it'll be this one this one in this one right these three guys will get the money and essentially they're going to pay the lowest interest rate they're going to pay the highest interest rate that the worst amongst them is willing to pay so this money is going to go to these three guys and essentially let's just say at seventeen point nine percent Interest all right seventeen point nine percent Interest it's going to be lent to these three guys right and I'm making a lot of simplifying assumptions but I really just want to get the underlying idea and these projects these three projects are not going to get done 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 this was a twelve percent yield project if somehow the capital was there we've got a 12% return as 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 there wasn't 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 over the course of the year because that's what the Fed is targeting so as we get away from the as we get away from the planting season these projects disappear these projects disappear they're no longer there because the planting season isn't there anymore and let's say you know this guy got done but let's say there's another project just like it that's 19% and all of a sudden since the planting season is done none of the farmers want money anymore but if you're keeping the money supply constant now which projects are going to done well this this good project here is going to get done but so are these two kind of crappy projects and they're going to be lent at a much lower rate they're going to it's going to you know the average rate that it gets lent to is going to be 1 or 2 percent or something really low so what what you have a situation here is that 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 and then later when kind of 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 I mean remember these are these are what the investor thinks that they're going to get but maybe there's a lot of risk and these end up you know if the investor thinks are going to get 1% return maybe they made a mistake maybe they'll get a minus 5% return in which case we're going to be destroying wealth so this is the problem where over a 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's a lot of demand for them and then you'll be investing in bad projects when there's a when there's not much demand for projects on the other hand if you had let's do the same scenario over again like I made that a little messy let's say you have a couple of farmers again let me draw a line here so you had the 20 percent 18 percent 12 percent and then you had the in I'll draw ball in yellow then you had the nineteen percent three percent and one percent now if if you had 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 but as we saw when you inject reserves into the banking system it lowers the rate that reserves are lent to each other but it also increases the lending capacity of banks so it increases the money supply 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 you're increasing the amount of money maybe the project's haven't changed that much so more money chasing the same number of projects the cost of lending is going to go down right so let's say the Fed manages the interest rate in such a way that you know that the Fed target rate was 5 percent but let's say that turns into bank lending to real projects at I don't know at 8 percent at 8 percent right 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 are going to get funded this one this one this one and this one and these guys are not going to get funded and then once the planting season 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 do they manage to the interbank lending but it's all related I just want to give you a sense of why it makes more sense to manage to an interest rate so once the planting season is over and some of these projects aren't really available as projects what were the 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 flushed with cash that they're chasing bad projects 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 it allows the money supply to expand and contract naturally in real time according to market demands for cash and by setting the interest rate you're essentially setting the threshold over which you're willing to let projects only that meet that threshold get funded and not you know projects below it that might somehow waste money anyway we'll discuss this a lot more in a lot of different videos and hid it from different angles but I just wanted to answer those questions just so you know that you know this wasn't some convoluted crazy thing that they're doing although it is a little bit convoluted it's just not that crazy anyway see you in the next video