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. 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 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. 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.
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.
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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 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.
What Are Interest Rates? | Interest Rates | Mozo
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. THE F. Its troubled parent was the recipient of federal bailout funds, and competitors successfully persuaded the Federal Deposit Insurance Corporation to pressure Ally to lower the rates it was paying to consumers.
Nobody wants a run-in like that with the F. Some of the best-paying accounts right now are not traditional banks or credit unions. Instead, these rates come from Sallie Mae and American Express, both new to the online savings game. Both seem healthy enough to stay out of the F. Surprising, that is, until you consider what it really means to serve. Credit union members putting money into certificates of deposit would love to earn more, and they often do get a bit more than they would from a nearby megabank.
But members who are borrowers want to pay less for their loans, and they often do. Hampel of the credit union association. Surely there must be an institution strong enough to do that or willing to do it to build good will. Even in this environment, however, companies may not need all of the potential deposits. Sallie Mae started its savings account and C. It is offering one of the best rates in the country, a 1. Yield to maturity is a bond's expected internal rate of return , assuming it will be held to maturity, that is, the discount rate which equates all remaining cash flows to the investor all remaining coupons and repayment of the par value at maturity with the current market price.
Based on the relationship between supply and demand of market interest rate, there are fixed interest rate and floating interest rate. Based on the changes between different interest rates, there are base interest rate and cash interest rate. Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables like investment , inflation , and unemployment. The central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country's economy.
However, a low interest rate as a macro-economic policy can be risky and may lead to the creation of an economic bubble , in which large amounts of investments are poured into the real-estate market and stock market. In developed economies , interest-rate adjustments are thus made to keep inflation within a target range for the health of economic activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.
In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0. The interest rates on prime credits in the late s and early s were far higher than had been recorded — higher than previous US peaks since , than British peaks since , or than Dutch peaks since ; "since modern capital markets came into existence, there have never been such high long-term rates" as in this period.
Some economists like Karl Marx argue that interest rates are not actually set purely by market competition. Rather they argue that interest rates are ultimately set in line with social customs and legal institutions. Karl Marx writes:. In many law disputes, where interest has to be calculated, an average rate of interest has to be assumed as the legal rate.
If we inquire further as to why the limits of a mean rate of interest cannot be deduced from general laws, we find the answer lies simply in the nature of interest. The nominal interest rate is the rate of interest with no adjustment for inflation. The real interest rate measures the growth in real value of the loan plus interest, taking inflation into account. The repayment of principal plus interest is measured in real terms compared against the buying power of the amount at the time it was borrowed, lent, deposited or invested. The real interest rate is zero in this case.
The real interest rate is given by the Fisher equation :. For low rates and short periods, the linear approximation applies:. The Fisher equation applies both ex ante and ex post.
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Ex ante , the rates are projected rates, whereas ex post , the rates are historical. There is a market for investments, including the money market , bond market , stock market , and currency market as well as retail banking. According to the theory of rational expectations , borrowers and lenders form an expectation of inflation in the future. The acceptable nominal interest rate at which they are willing and able to borrow or lend includes the real interest rate they require to receive, or are willing and able to pay, plus the rate of inflation they expect.
The level of risk in investments is taken into consideration. Riskier investments such as shares and junk bonds are normally expected to deliver higher returns than safer ones like government bonds. The additional return above the risk-free nominal interest rate which is expected from a risky investment is the risk premium. The risk premium an investor requires on an investment depends on the risk preferences of the investor.
Evidence suggests that most lenders are risk-averse.
A maturity risk premium applied to a longer-term investment reflects a higher perceived risk of default. Most investors prefer their money to be in cash rather than in less fungible investments. Cash is on hand to be spent immediately if the need arises, but some investments require time or effort to transfer into spendable form. The preference for cash is known as liquidity preference. A 1-year loan, for instance, is very liquid compared to a year loan.
A year US Treasury bond , however, is still relatively liquid because it can easily be sold on the market. Assuming perfect information, p e is the same for all participants in the market, and the interest rate model simplifies to. The spread of interest rates is the lending rate minus the deposit rate. A negative spread is where a deposit rate is higher than the lending rate. Higher interest rates increase the cost of borrowing which can reduce physical investment and output and increase unemployment.
Higher rates encourage more saving and reduce inflation.
Interest rates explained
The Federal Reserve often referred to as 'the Fed' implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds , which are the reserves held by banks at the Fed.
Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates using the power to buy and sell treasury securities. Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. Generally speaking, a higher real interest rate reduces the broad money supply.