Okay, another Econ question from me that I am puzzled about.
We’ve been hearing for a couple of weeks now how banks don’t have any liquidity. They’ve got so much toxic paper that they can’t/won’t lend money to anyone, not even each other. This is creating a credit crunch; businesses can’t borrow to expand, consumers can’t borrow for car purchases, mortgages are tight, etc.
Right. So today the FED lowers the target for the federal funds rate, the rate that banks lend to each other, from 2 percent to 1.5 percent. This will also lower interest rates throughout the economy in an indirect way. Here is what confuses me:
The problem was never that people didn’t want to borrow. Businesses and consumers would LOVE to borrow, but banks don’t want to/can’t lend. By lowering the funds rate, and by default the interest rate, won’t banks be even LESS likely to lend money now?
It seems to be, if I understand the problem, that the right response would have been to raise the federal funds rate so that a bank could see a greater return on loans, and be more likely to lend, loosening credit.
/Here is the Wikipedia on the Fed Funds rate. If I can borrow money from you at a *lower *rate today than I could yesterday, do you think I might be more likely to lend it out to someone else now?
Yesterday, I can borrow money at 2% and loan it out at 6%
Today, I can borrow money at 1.5% and loan it out at 6%.
That’s why the Fed cut should free up money. My example is hypothetical, but is an illustration of what happens with this type of cut.
But, using your hypothetical, I wasn’t loaning out money yesterday at 2%. I was holding on to it for fear of the economic slowdown and/or I couldn’t loan any money because mine was all tied up in these bad mortgages.
So, since I wouldn’t loan you any money yesterday at 2%, why would I loan it to you today at 1.5%? As I said, the problem was not people like you (in your example) wanting to borrow money. It was people like me refusing to lend…
The supply of fed fund loans is relatively inelastic–that is, relatively insensitive to interest rates. Fed funds are reserves that banks loan to each other, not ordinary commercial loans. They’re very short term (usually overnight) and very low risk, and there isn’t much else a bank can do with excess reserves. (In theory they can withdraw the excess reserves and invest elsewhere, but for a small bank that entails transaction costs, especially since they may need to build back their reserves quickly.)
Demand, on the other hand, is relatively elastic, for the reasons given by dalej42. A bank might like to make a large commercial loan, but knows that if it does it will need to increase its reserves–a more attractive proposition when it can do so at 1.5% rather than at 2.0%.
The Fed doesn’t really set the nominal federal funds rate directly. The 1.5% quoted rate is just the Fed’s target, the rate at which it would like to see banks loan one another money. What it actually does is manipulate the money supply by injecting or removing money. When it wants to lower the rate, the Fed buys up securities held by banks. It may buy them under a repurchase agreement (the bank will buy the securities back from the Fed later) or it may just buy the bank-held securities outright. In either case, the bank now has more money in its reserve account than it did before. With these additional reserves, the bank is capable of making more commercial loans if it so chooses while still meeting the federally mandated reserves levels. Alternatively, it can loan these additional reserves to other banks. But since there is an increased supply of reserve funds relative to demand, the lending rates negotiated between banks should fall.
Freddy and Caldazar got and I’ll just add a re-up an old post of mine that has a helpful graphical model.
The Central Banks do not raise or lower rates.
They set a target rate they would like to see commercial banks lend to each other their reserve balances kept at the Fed. To achieve this target they expand or contract the supply of money. To expand they print up some dollars and exchange it for treasuries and other collateral from banks. More money is floating around the system therefore it is less scarce and cheaper to get i.e. lower rates. They raise the target rate by doing the opposite.
I looked around for a decent graphical model that wasn’t a .pdf or .ppt and this was the best I could find.
Interest rates go up on the left side. Output of the economy is across the bottom, increasing left to right.
The IS line is Investment/Savings
While it’s dangerously close to oversimplifying the LM line is the money supply.
Ignore the BP line for our purposes
If you look to the left there are some mouse over links. Pick the one under Monetary Stimulus - Fixed. When you mouse over that you can see the LM line shifts to the right (the new red LM line) representing an increase in the money supply. The intersection of the IS and LM lines is now lower (as in lower interest rates, demonstrated on the left axis) and shifted to the right or greater investment/savings. We also have a higher output for the economy, as shown by its move along the bottom.
Anyway this is a very simple model to help with the general concept. It can get incredibly complicated from there and many economists think it’s complete bullshit.
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