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Banking 16: Why target rates vs. money supply

The rationale for targeting interest rates instead of directly having a money supply target. Created by Sal Khan.

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  • blobby green style avatar for user manodud
    Why wouldn't the Fed lend directly to banks and set the interest rates in a more direct way rather than setting a target rate and letting banks lend each other? Is that an open market principle?
    (11 votes)
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    • mr pants teal style avatar for user Martin Christensen
      They actually do that as well. There are basically two ways for a bank to borrow money: on the inter-bank marked where the banks lend eachother money over night, or borrowing from the FED. The FED will lend the banks the money for a certain interest which creats a ceiling for the interest rate on the inter-bank marked (why borrow from other banks, if you can borrow more cheaply from the FED). Also, the FED will pay the banks to deposit money if they have too much cash. This creats a bottom for the interest rate on the inter-bank money marked.

      The basic idea of this is to make sure that the interest rate would suddenly drop or explode from one day to another.

      So why these OMOs (open marked operations). Well, we have to keep in mind why the interest rate would increase in the first place. That would be due to a larger demand for money. Forcing the interest rate up doesn't actually do anything about the demand for money. Lets say we have 1 million dollars, the interest is 8% but the demand for money at an interest at 8% is 2 million dollars. What happeneds then? Well if we dont use OMOs the money supply wont increase and since the FED controls the interest rate, that wont change either. So basically the demand for money will be greater than the supply thus some people and/or companies will not be able to borrow the money they want!
      (16 votes)
  • blobby green style avatar for user fratolill
    Why is there no mention of the NEW MONEY that was created by the high returning projects? It would seem that the return on these projects would also have an effect on the money supply and future borrowing.
    (5 votes)
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  • mr pink red style avatar for user Mustafa
    At the moment the current American interest rate set by the FED is 0.25%, is this a good idea considering some of the investment projects are very shady and likely to fail? I'm not sure if this is the actual rate, I got this information from www.global-rates.com.
    (3 votes)
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    • leafers ultimate style avatar for user J.L.Savard
      It seems to me that heuristic123's question is valid in principle. Even though "No one finances capital projects at the Fed funds rate", is it not true that the rate at which one finances capital projects will be influenced by the FED funds rate? I.e., lower funds rate resulting in generally lower financing rates for capital projects (and vice-versa)?
      (3 votes)
  • leaf grey style avatar for user jean-marc moly
    At , M2 is defined, but ... could someone give me more specifics?
    (2 votes)
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  • purple pi purple style avatar for user Peter
    at , Sal says they three borrowers get the money at 17.9%
    It doesn't seem to be an average of the three numbers.
    Is it just a nominal "typical" figure Sal picked ?
    Certainly I remember when many loan rates WERE as high as 17.9%, but that was (excluding "poor" credit options) 10 years ago, or so. But now (2014) I would expect to pay a half of that, or perhaps even a third.
    So is the 17.9% just a "typical" rate?
    Or is there a more direct link between the numbers on the "blackboard" and the 17.9%?
    (2 votes)
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  • blobby green style avatar for user jy.weissberg
    I'm unclear on the benefits of a centrally controlled contracting / expanding money supply as opposed to a money supply without immediate control (gold).

    It's also useless to look at the US after the 1970s and conclude fiat money is superior since we have no data against which to benchmark one economic system vs another; there are no experiments in economics. I think then the only way to deal with this is abstractly, rather than a concrete by concrete basis.

    Can anyone recommend additional reading ?
    (1 vote)
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  • leafers ultimate style avatar for user Ori
    Since the Fed works on meeting the target lending rate between banks, do banks have some degree of control on the system? In other words could banks pressure the Fed to expand or contract the money supply by changing their interest rate? (I realise there are unlawful and lawful ways of doing so - in this case let's focus on the lawful means)
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Firstly, the banks don't have to listen to the Fed. Banks can charge any interest rate they want, as long as the other party agrees. Secondly, the banks have almost complete control. They tell the Fed what to do. This is because the board of directors for each of the reserve banks are divided into three classes of three people each. Class A directors represent the member commercial banks in the District, and most are bankers, and both class A and class B directors are elected by member banks.

      This was designed so that banks would have a large amount of control over the Fed. This is mainly a good thing, since it eliminates the problem of the Prisoner's Dilemma which greatly harms the financial system.
      (3 votes)
  • blobby green style avatar for user xthehunterz
    Lets say that the US wants to increase the fed rates.To increase the rates,it must decrease the money supply. So it sells T-Bills to people to get the money off them. Now that people have got T-Bills which the government is obliged to pay.
    Now lets say that the government wants to keep these increased rates to be stable for 10 years.Does that mean that fed won't buy those T-Bills off people for 10 years? Why would common people hold T-Bills for that long?
    Or simply put,how can the government keep on increasing fed rates for a long time?
    (1 vote)
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  • duskpin ultimate style avatar for user tuannb1997
    Why is it necessary that money be allocated to fund crappy projects ? Instead of wasting money on shady, unreliable investments banks could have saved - or reserved - that amount of money to increase their liquidity, couldn't them ?
    (1 vote)
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  • blobby green style avatar for user Jarrod
    Does the money supply ever actually contract?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      When the Fed decides it wants contraction, it makes it happen by selling treasury securities for cash. Because the economy is usually growing, it's not usually necessary to actually make the money supply smaller. Just having it grow at a rate less than the economy is contractionary. But they have on occasion made some measures of money supply actually contract.
      (2 votes)

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 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-- $2 trillion. 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. 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 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 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. 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 this project. Fair enough. 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 projects disappear. 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 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-- 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.