Every once in awhile I hear about the feds raising or lowering the “interest rate”.
I have no idea what this means. What interest rate?
Can somebody explain this in simple terms, or at least point me toward a site where it is explained for the layperson? I know very little about economics, although the recent crisis has forced me to brush up on the basics.
There are several different interest rates; the Federal Reserve (“the Fed”) wiggles them around from time to time.
The Federal Reserve is the country’s central bank. The Fed’s job is to manipulate supply and demand in the currency market by tweaking the interest rates at which they lend money to the big banks.
Let’s say Big Bank A needs to quickly borrow some money to cover withdrawals by its customers. They go to the Fed and ask for an overnight loan. The fed tells them how much interest they’ll have to pay. That interest rate is the cost of the bank borrowing money. If it’s low, the bank can turn around and use that money to make relatively low interest loans (credit cards, mortgages, car loans, whatever) to consumers. This expands the money supply. If the rate is high, Big Bank A will have to increase their own interest rates to make a profit. This makes borrowing more costly for consumers, and reduces the money supply.
The Fed does this to manage their economic policy, which is generally to act as a moderating influence and to try to maintain stability. It’s also a gross oversimplification; the actual setting of interest rates has to due with auctioning Treasury securities and weird shit which I’ve never been able to understand.
When the Federal Open Market Committee buys Treasury securities anonymously in the open market, it increases the amount of cash in circulation. More cash means it is easier to borrow and lend (cold hard cash responds like any other scarce resource to alterations in its supply and demand) and so the interest rate (the price of cash) falls. When FOMC sells its Treasuries, the reverse happens, and the interest rate increases.
How do they do it anonymously? Wouldn’t people notice that every time the Fed announces an interest rate cut/increase, a Mr. Fake A. Name buys or sells a bunch of treasuries?
Here’s a simple overview of the creation of money by the central bank. It doesn’t include interest, but that should be easy enough to imagine. Then just imagine that instead of the central bank loaning directly to people, it instead loans to other banks, who then loan to people.
The lower the interest rate, the more people will take on a loan, the larger the interest rate the fewer people that will go for a loan. People only take loans so that they can spend money–and hence this is a way to control the amount of money people are spending in general. If they’re creating a bubble in the economy by overspending, you raise the interest rate and pretty soon people are holding back on their investments.
The Fed doesn’t buy anonymously. It performs open-market operations in conjuction with the banks that have reserve accounts at the Federal Reserve. When the Fed wishes to increase the money supply, it buys securities held by the banks and deposits cash into the banks’ reserve accounts. When the Fed wants to decrease the money supply, it sells securities to the banks in exchange for the banks’ cash. Open-market operations are typically auctions or bids of one sort or another.
I liked your October answer Caldazar so I’m going to post it again and follow with my boilerplate answer.
Caldazar - 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.
Mongo - 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. By the way Fiscal Stimulus is government spending as opposed to Monetary Stimulus which is the Fed toying with money supply.
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.