This is a good explanation. I have seen several videos and articles trying to explain it and they are all good in one way or another and yet I still have questions. You might think about doing one of those Live RU-vid shows but just for teachers. Either way, thank you for this.
@@navyadandu208One correction to your question. The Fed is not "counteracting high interest rates," they are fighting either inflation or recession by manipulating the interest rate. In the current Ample Reserves System the Fed targets a higher Federal Funds Rate (FFR) to fight inflation and a lower FFR to fight recession. Currently the Fed influences the FFR by bracketing it between the Interest Rate on Reserve Bonds (IORB), which the Fed directly controls, and the Overnight Reverse Repo Rate (ON RRP). In the old limited reserves system the fed manipulated the money supply to change the interest rate by buying or selling bonds, increasing or decreasing the reserve ratio and/or the discount rate. All of this is done to fight inflation or recession. Right now, in the real world, the Fed is targeting a higher interest rate in order to slow inflation. Good luck on the exam.
The ON RRP offering rate is available to some large financial institutions that do not have reserve balance accounts at the Fed. This rate is set below the interest on reserve balances rate, so it helps set a floor for the federal funds rate and is the ACTUAL floor and not the interest on reserve balances.
Very Nice. Thanks for your efforts! Carey, Can you check and see if my commentary below on your ample reserves discussion is correct , because your explanation of how the Money Market diagram relates to the Ample Reserves Diagram was confusing to me? 1. On the FFR (Fed. Funds Rate) vs Reserves diagram, the Vertical Reserves Supply Line is so far to the right that if it shifts a little (or a lot really), it wont affect the FFR rate. 2. If we change FFR via the Administered rates then the following sequence occurs: FFR increases, then nominal rates eventually increase, then Money Supply decreases Note that the Money Supply (M1 or M2) does not include the Reserve Supply. Reserve supply is about 14% of the M2 today (i.e. M2 is 7x bigger than Bank Reserves). So the M2 world is a lot bigger and one can imagine that if we raise nominal rates sufficiently, this will cause people to spend less and save more (or invest in Bonds for example), causing Overall Money Supply as represented by M2 to drop. So what we are saying is... bank Reserve Supply today is not as impactful on the FFR due to Ample Reserves, but overall short term interest rates can still be impactful on M2 which is about 7 times the size of Bank Reserves. Does the logic sound right? Thanks again.
How much of a free market do we have when the Fed controls interest rates in either regime? The free market has very little to say with the Fed Funds rate. Hello central planning.
If I’m understanding the model correctly the resulting decrease in the MS is caused by the decrease in lending by banks brought about by the increase in IORB.
@@glennwatson3313 by my lights: the other way of thinking about it is the Fed setting the initial IOR which in turn determines the initial nominal interest rate which then connects to the MD curve, determining the initial MS. Likewise the Fed raising IORb in turn raises THE nominal interest rate which then connects to the MD curve at a lower quantity, resulting in a lower MS. Essentially where the interest rate ‘connects’ to the MD curve determines the money supply.
@@markbirmingham6011 I read your post three times. You lost me. Let me try again while looking at the graph. OK, here is what I think. The Fed sets the IORB and the ON RRP as a floor below which the Federal Funds Rate (FFR) will not go. The Fed sets the Discount Rate above which the FFR will not go. In this way the Fed set a target range for the FFR which indirectly influences nominal interest rates as commercial banks. If nominal interest rates increase demand for loanable funds decreases. The demand for money in your pocket also decreases as interest rates increase because you want to deposit that money to get the relatively higher interest rate. The Fed would increase the IORB in order to increase the FFR and ultimately the nominal interest rates banks charge customers. The Fed is doing this to fight inflation.
@@glennwatson3313 that’s the general idea by my lights. I would just describe the loanable funds market as a change in quantity demanded of loanable funds as interest rates are on the vertical axis in the loanable funds market, so the curves don’t shift when interest rates change. Because the higher interest rate is now ‘fixed’ we’d have an effective floor preventing the loanable funds market from returning to equilibrium. The quantity supplied of loanable funds would be greater than the quantity demanded for loanable funds. Which to me makes sense, including reserves (potential bank loans) in the loanable funds supply curve, we’re in a situation where it’s loan demand that limiting growth in the M1 MS. The reserves clearly are available to make loans.
If anyone reads this thanks for being a sounding board. In grad school I focused on integrating fractional reserve banking into economic theories. I would argue that in the loanable funds market (assuming ample reserves) the fed is essentially setting the interest rate, which based on the demand curve for loanable funds, determines the amount of actual lending. The supply of loanable funds now vastly outstrips the demand for loanable at ‘all’ interest rates. In an ample reserves world, Resulting decreases in loans due to higher interest rates is solely due to changes in the quantity demanded for loanable funds. At each interest rate there would a resulting surplus of loanable funds, but the quantity demanded of loanable funds would still be met.
I’m just spitballing, but by my lights the causation train is a bit off at the end. Decreasing administered interest rates, lowers the FFR, which lowers interest rates, causing an increase in quantity demanded of money which the banks then meet via increased lending-increasing the money supply. Conversely, raising IOR, raises the FFR, which raises interest rates, which lowers the quantity demanded of money, causing a reduction in bank lending resulting in a reduction of the money supply. In short, it’s the dynamics (elasticity) of the MD curve in response to changes in interest rates that driving the resulting change in MS.
But the MD curve is nearly perfectly elastic where the supply curve intersects demand in the ample reserves system. Shifting supply only works in the old limited reserves system when the demand curve is inelastic.
@@glennwatson3313 by my lights, the demand curve for RESERVES is perfectly elastic in the ample reserves model (this is the demand by banks for reserves, which are not part of the M1 MS) while the quantity of money demanded on the MD curve is still sensitive to changes in the nominal interest rate which is brought about by changes in IOR (administered interest rates). Suppose the fed lowers IOR, for that to have any effect it would need to lower the fed funds rate, which in turn lowers the nominal interest rate. Interest rates move together. Given that the nominal interest rate goes down the quantity of MD increases. What then drives the resulting increase in the M1 supply other than an increase in demand deposits i.e loans? Some of the increase could be due to increased cash withdrawals and people liquefying bonds into demand deposits. But I would think loans-new demand deposits- make up the bulk. I know in the graph the MS curves are shown as vertical, indicating it is ‘controlled’ by the Fed. But all the Fed is doing is changing interest rates. For the shift in the MS to be explained, it has to reflect some change in the M1 MS and by my lights the most probable explanation is a change in lending practices shifting the M1 MS until MS=MD at the new nominal interest rate. Also the MS curve must shift in order to keep the market in equilibrium. I’m open to other explanations.
