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 we have a target M0 of-- I don't know--
$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.
So similarly, they could have a target M1.
They could say we want the M1, which is the M0 plus checking
deposit accounts-- 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 can say, we want that target to be-- I don't know--
They can say, we're targeting the M2.
M2 is the M1 plus savings accounts and
money market accounts.
So they could say, we're targeting
that to be $8 trillion.
And just so you know, I actually
looked up these numbers.
As of at least '05, '06, these numbers weren't that far off.
The M0 was more like $800 billion, but just
so you get an idea.
These, are real numbers.
The obvious question is, why don't they do that?
Why don't they just grow the money supply?
Maybe one thing they could do, they could say, our goal is
for M2 to always be-- 50% of GDP, right?
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, then it'll have a multiplier effect
and we'll just keep measuring it.
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.
So that's a completely legitimate way of thinking
about it-- and actually, there are some people who do
advocate it this way.
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.
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 banks are lending
to each other at, I could just sample the market at that
moment in time.
I could say, I'm a bank.
What are you willing to lend to me at?
They'll say, 5.2%.
They're 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 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.
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 the planting season.
I've never been a farmer, but I think the planting season is
sometime in the spring.
And let's say there's a couple of farm projects where 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 at 21% interest
rate, he'll be like, no, that's way too much.
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
Say there's another farmer with an 18% project.
So if he gets 18% or lower interest rates, he'll proceed
with his project.
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.
Let's say there's a couple of other
projects in this universe.
Let's say there's a factory guy.
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.
And let's say there's another factory guy who
would get 3% funding.
So he's not too confident about his project.
He thinks this project only makes sense to move forward if
he can get 3% or better funding.
So when I say better, less than 3%.
My phone is ringing, but I'll ignore it
because I'm on a roll.
And there's another guy who's really marginal, really shady.
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 in in the spring or
during the planting season.
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'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-- 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.
So in a capitalist system, the three best projects
would get the money.
And so it'll be this one, this one, and this one, right?
These three guys will get the money.
And essentially they're going to pay the highest interest
rate that the worst among them is willing to pay.
So this money is going to go to these three guys at
essentially 17.9%, right?
I'm making a lot of simplifying assumptions, but I
really just want you to get the underlying idea.
And these projects, these three products 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 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.
There wasn't enough money at that moment in time to support
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.
So as we get away from the planting season, these
They're no longer there because the planting season
isn't there anymore.
And let's say 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'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?
Well, 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.
The average rate that it gets lent to is going to be 1% or
2% or something really low.
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.
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.
Maybe they'll get a -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'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
not much demand for projects.
On the other hand, if you had-- let's do the same
scenario over again.
I think I made that a little messy Let's say you have a
couple farmers again.
Let me draw a line here.
So you have that 20%, 18%, 12%, and then you have the
19%, 3%, and 1%.
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?
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.
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 projects 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 the Fed target rate was 5%, but let's say that
turns into bank lending to real projects at-- I
don't know-- 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 products are
going to get funded?
This one, this one, this one, and this one.
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 isn't what
they manage it to.
They manage it to the inter-bank lending, but it's
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-- 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.
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 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.
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.
It's just not that crazy.
Anyway, see you in the next video.