Banking 16: Why target rates vs. money supply

TL;DR

The Federal Reserve sets target interest rates instead of target money supplies due to convenience and the ability to account for real-time information.

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 c... Read More

Key Insights

• 🤑 The Federal Reserve chooses to manage the money supply through target interest rates because it provides real-time information and convenience.
• 🤑 Setting interest rates allows for the natural expansion and contraction of the money supply based on market demands for cash.
• 📽️ Targeting interest rates ensures that only projects meeting a certain threshold are funded, preventing the allocation of resources to potentially wasteful projects.

Questions & Answers

Q: Why doesn't the Federal Reserve set a target money supply instead of target interest rates?

Setting target interest rates is more convenient as it allows for real-time measurement and adjustment. Measuring money supply would require surveys or complex calculations, which could be messy and time-consuming.

Q: What are the components of M0, M1, and M2?

M0 consists of base money or Federal Reserve deposits/notes. M1 includes M0 plus checking deposit accounts. M2 encompasses M1 plus savings accounts and money market accounts.

Q: Why do some people advocate for managing the money supply to a percentage of GDP?

Managing the money supply to a percentage of GDP, such as targeting M2 to be 50% of GDP, ensures that the money supply grows in line with the economy. It allows for adjustments to prevent an imbalance between money supply and demand.

Q: What are the drawbacks of holding the money supply constant?

Holding the money supply constant over a medium period can lead to funding good projects when there is high demand while funding bad projects when there is less demand. This can result in missed opportunities and potentially negative returns.

Summary & Key Takeaways

• The Federal Reserve could manage the money supply by setting a target M0, M1, or M2, but they choose to set target interest rates instead.

• Targeting interest rates is easier to measure in real-time compared to measuring various money supply components.

• Managing interest rates allows for the natural expansion and contraction of the money supply based on market demands for cash.