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Banking 16: Why target rates vs. money supply

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The rationale for targeting interest rates instead of directly having a money supply target. More free lessons at: http://www.khanacademy.org/video?v=yOgGhPIHnlA
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Nonamename Nonamename (9 months ago)
And at the end each and every other farmer thinks the same, they all borrow since the rates are low, they plant the seeds and and up with huge supply of seeds at the end of the season and to big supply of them on the market. So what happens is the price of seeds drops. And then the government steps in and saves the farmers for our money creating more deficit. So the goverment borrows by emmiting more IOUs. And we all end up with cheep seeds we do not need and debt which is a huge missallocation of resources.
Nonamename Nonamename (9 months ago)
but the economy spins and the currently elected government can tell us how well they did with last crisis and that the GDP is soaring, and look they even saved the farmers in the mean time :)
Ted Kamiński (1 year ago)
One of the major reasons the FED doesn’t control money supply directly is because of the eurodollar market. Eurodollars are dollars outside of the US, which the FED had no control over ( or insight into ). As Milton Friedman said, they were created with the strike of an accountants pen. For those interested I’d recommend the Macrovoices podcast, episodes titled Eurodollar University.
Pharaoh on LFS (4 years ago)
At the end I do believe a constant money supply would not have that negative affect. When good projects are successful it should have downward pressure on prices through competition as new businesses enter the markets. As people save money on products, they'll save more in the banks. As the banks have more money to lend out, rates should lower. The free market will ALWAYS figure out the best rate. If the rate is high, it's an incentive to save, if rates go down, it's an incentive to borrow. Cetaris paribus 
Jacob Clifton (5 years ago)
I am by no means a banking expert, but isn't the scenario you presented non-existent (where we are "forced" to lend to crappy projects)?
Srijit Sanyal (6 years ago)
This is hilarious. Khan appears to have forgotten his basic intermediate macro (let alone the more advanced stuff). Changing the amount of money in the economy is NOT the same as changing the amount of saving or even loanable funds. HINT: distinguish between real and nominal. His is a proposal for inducing recessions, as a simple ISLM analysis would show. He's confused between intermediate targets (interest rates) and goal targets (prices/inflation). Also fails to dist. private vs. social costs.
spark300c (7 years ago)
problem is not that it is elastic with demand but rates should risk and if inflation happens it because of bad projects and now rate have to be higher to prevent speculation. interest rates should change as inflation happens to try pop assets bubble early. people take out loans to speculate on prices.
spark300c (7 years ago)
problem is that government debt becomes unsustainable. deflation happens because of bad bets when they came due. inflation happen when bad bets were made. now fed must fight inflation to keep the government debt bubble going become no one want to buy toxic assets.
john doe (7 years ago)
ignored the phone coz he's on a roll lols....
jason Parenteau (7 years ago)
@tnekkc The assumption Kahn makes in that statement is that everbody acts logically, with data and statistics and margins of error and whatnot. Of course there are idiots out there who 'think' they have some great idea and would borrow at ridiculous high interest rates. Just watch an episode of "Dragon's Den" or "Shark Tank" (depending on where you're from) and you'll see all the idiots out there. Large corporations and succesful businesses generally won't make those mistakes.
Zoe Jane (7 years ago)
It made me to realize the demand and the supply again. I always heard of demand and supply, but seldom actually use them in the reality. But now I found that it is not the quality of something, but the demand and supply of something determined our most daily actions and decisions.
IvanAndreevich (7 years ago)
And the government is supposed to know when the time for good projects is? LOOOL. Only the market knows that.
cepson (7 years ago)
3 people were pissed he wouldn't answer their phone call.
Clark Magnuson (8 years ago)
Good projects are those willing to borrow at a higher rate? I don't think so. Kahn fail.
Brian Huxtable (8 years ago)
@tseelonb Asset and credit markets do not act like goods and service markets which follows supply/demand optimization. Lending money increases economic activity which in turn reduces interest rate causing even more lending. This causes a boom, opposite happens in a bust/recession.
MrFilippo (9 years ago)
I'm sorry but is a very risky thing to teach that Fed(government) is going to change the money supply to properly allocate the lending towards worthy projects! When the hell the government got the know-out to single out about good projects in the market? When not even banks at this time have a clue where the price of certain products is. Well one thing is certain that the monetary policy failed as banks didn't lend consequently each other!!
Richard Plender (9 years ago)
To illustrate my point: economistsview.typepad.com/.a/6a00d83451b33869e20120a679e1bf970c
Richard Plender (9 years ago)
Sal you missed one of the most critical points on why the Federal Reserve doesn't target the money supply. The reason is not that the money supply is hard to measure for the technical reasons you mentioned but because as financial innovation has proceeded over time the boundaries between M1 and M2 have become much more fluid, making monetary aggregates impossible to define and the velocity of money erratic.
biagio lembo (9 years ago)
yes but maybe 19% ROI projects are chinese crappy toys and 3% ROI projects are antidesertification projetcs (very low economic return but very useful for our environment)
Johnny Sorensen (9 years ago)
Sal, your comments on elastic money supply is the main cause of the mess we are in... Please rethink your arguments... flexible money supply does not work..., Why do you want a goverment bureaucrat to decide if a 2% project should get funded or not?.. if a saver think 2% i enough... then 2% is enough.,. do not let goverment decide it,,, greenspan proved that he couldnt do it. Please read more of mises and rothbard.. i have forced to rate this video as poor, due to information in video.
Duaner (9 years ago)
And let's not forget that all these treasuries the Fed has bought will be due with interest. Interest the government will not have. The banks just soaked up the cash. Nobody wants to borrow it. M1 remains the same. The bankers actually take a bunch of it and put it into their personal accounts (AIG). This system requires some serious assumptions.
Duaner (9 years ago)
Another reason for not targeting M1 is that it depends on people's willingness to borrow, which isn't always there. As we can see during much of 2009, even with virtually zero rates, that isn't getting people borrowing and therefore M1 isn't increasing as expected.
dsws2 (10 years ago)
Does money supply have to do particularly with new projects undertaken, or is that just an example? I thought it was mostly intended ordinary purchases versus money in checking accounts. An increase in checking account balances happens whenever money gets deposited into checking from a source other than another checking account. That can be a new loan, or it can be from CD, money market, etc. For individuals, isn't that mostly a matter of expectations about paychecks vs spending?
jackuy12345 (10 years ago)
keep them up!!!!
Khan Academy (10 years ago)
They are both actually consistent actions with increasing the money supply. As long as inflation does not become an issue and the total government debt does not become unsustainable, the Treasury could issue more and more debt which essentially gets bought by the Fed with newly printed notes. This is the Fed's last tool to fight a deflationary spiral.
Jimmy D. (10 years ago)
Assuming the amount of transactions can keep up with the cost of staying in business.
Khan Academy (10 years ago)
Just to hit the point home, let's say that you start with $.99 that you use to buy an apple which you sell for 1.00 (so .01 gross profit or 1% gross margin). You can then use the 1.00 to by another apple and repeat. If you do this 100 times in a year, you will make upwards of $1.00 (since you can reinvest the profit) on a .99 initial investment. That is a 100% return on investment despite only making a 1% margin on each transaction.
Khan Academy (10 years ago)
Those percentages aren't expected returns, they are the funding rates at which the projects would proceed. My point is that by focusing on rates, the "quality" threshold for projects stays constant. Also, low gross/operating margin at a retailer doesn't mean a low expected return on their investment (I'll eventually do a playlist on topics like that).
Pete North (10 years ago)
I have only understood about half of what I've seen from you. But I am better off for it. Thank you.
Barry Soetoro (1 year ago)
Don’t worry. It takes time to get familiar with the language. Once you do, it will click for you...also, get comfortable with the concepts associated with supply and demand. Very key
Jimmy D. (10 years ago)
Just because the expected return on an investment is low doesn't mean it is risky if it is a necessity, I believe that most supermarkets profit margin is low but they are high necessities. Other businesses are highly risky, i.e. airlines and automakers, yet can persuade banks and government to create loans. Why is there so much socialized baiilout for high risk businesses?

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