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Studying for a test? Prepare with these 5 lessons on The monetary system.
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Video transcript
Now that we know that we can view interest rates as essentially the price of renting money. I want to go through a bunch of scenarios just so we can understand how different things that happen in the economy might effect interest rates. I just draw a bunch of supply and demand curves right over here. Once again we're talking about the market for essentially renting money. That right over here is the price of money, which we know is the interest rate on the vertical axis. Then the horizontal axis we have the quantity of money that is borrow or lent in a given time period. Quantity and this is a given time period that is borrowed or lent. Quantity borrowed in a year. We know there is some ... if we just wanted to draw a demand curve our starting demand curve. The first few dollars out in the economy people are willing to pay a very high interest rate on them. Then every incremental dollar after that people get less marginal benefit. They might not find as good of a place to put that money. Their borrowing it for a reason. Their either going to borrow to consume to buy something that they always wanted that they think will make them happy, or more likely their borrowing it to invest it and hopefully getting a return higher than what they are borrowing at. You have a marginal benefit curve that would be downward sloping something like that. Maybe it looks something like that. That is our demand curve or our marginal benefit curve. The supply curve. Now, once again this is the exact same logic we use with the demand and supply curve for any good or service. For money might look like this. Those first few dollars someone has a very low opportunity cost of lending it out, so, their willing to lend it out at a very low interest rate. Then every incremental dollar after that theirs higher opportunity cost, and people will lend it out at a higher and higher rate. Then you have a market equilibrium interest rate. Let me copy and paste this. Then we could think about what happens in different scenarios. Copy and paste. Now we have 2 scenarios that we can work on, and then let me just do 1 more. 3 scenarios. Let's think of a couple. Let's say that the central bank of our country, in the United States, that would be the Federal Reserve, the central bank prints more money. Then decides to lend out that money. That actually is ... in the previous video I talked about the central bank printing money and then dropping it from helicopters, that is not how money is actually distributed. It is disturbed when central banks print money. The way that it enters into circulation in most countries is that the central bank then goes and essentially lends that money. The way it's done in the US Fed, most part they go out and buy government securities which is essentially lending money to the Federal Government. They do that because that's considered to be the safest investment. They go out there and they lend money. If this is our original supply curve. If this is our original supply curve, but now your Federal ... Central Bank is printing more money and lending it out. What is going to happen over here? Your supply curve is going to shift to the right at any given price, at any given interest rate. Your going to have a larger quantity of money being available. It might look something like ... your new supply curve might look something like that. Assuming that's the only change that happens you see its effect. Your new equilibrium price of money, the rent on money, or the interest rate on money is now lower. That's why when the Federal Reserves say I want to lower interest rates, they do so by printing money. They print that money, and they lend it out in the market. That essentially has the effect of lowering interest rates. Let's think about another situation. Let's say this is the Fed prints and lends money. Their lending the money by buying government bonds. When you buy a government bond, your essentially lending that money to the Federal Government . I've done other videos on that where we go into a little bit more detail on that. Let's think of another situation. Let's think about consumer savings go down. One interesting thing about savings, savings and investment are two opposite sides of the same coin. When you save money ... you literally put it into a bank. You have the whole financial system right over here. This is the finincial system. Financial system. That money goes out and is lent to other people. For the most part, hopefully, that money when it's lent is used to invest in someway. This is lending. If consumer savings goes down that means the supply of money will be shifted to the left. At any given price and any given interest rate their be less money available. In this situation our supply curve is shifting to the left. That would increase interest rates. Then you could even make an argument that if consumers savings is going down consumers are going to borrow less as well. You could argue that maybe demand would go up as well. Your demand could go up and that would make the equilibrium interest rate even even higher. Let's do another scenario. Let's say that the Federal Government in an effort to ... let's say that for whatever reason, their trying to finance a war or some type of public works project and they don't want to raise taxes. The government decides to borrow a lot more money. The government is essentially going expand it's deficit. The government is going to borrow money. Here our supply isn't changing. I'm assuming the Central Bank isn't changing it's policies, how much it's printing. Savings rates aren't changing. The demand is going to go up. Government is borrowing money. The government is going to borrow more money than it was already doing. At any given price the demand for money is going to increase. We're going to shift to the right, and our new equilibrium interest rate, remember the rental price of money, is going to go up. The whole point of this is just to show you that you really can't think about money like any other good or service. If the supply of money goes up then the price of money, which is interest rates, will go down. Let me write this down. If the supply goes up then the price, which is just the interest rates goes down. If the demand goes up, then the price of money will go up. Interest rates will go up. Then we think about all the other combinations where demand goes down, then interest would go down. Which is essentially just price. If supply went down, interest rates would go up. If something becomes more scarce the price of it goes up. The whole point of this is just to show that it's not that complicated. You'll see people say, oh, government borrowing, it's crowding out other savings, interest rates go up, and it sounds like something deep is happening. They are just talking about the supply and demand for money. You just have to remember that interest rates really are nothing more than the rental price for money.