Re: Money Supply, Credit Supply

From: William F Hummel (wfhummel_at_comcast.net)
Date: 06/25/04 

Date: Fri, 25 Jun 2004 15:35:49 GMT

On Fri, 25 Jun 2004 06:44:33 GMT, Mason A. Clark
<masoncNOT@THISix.netcom.comQQQ> wrote:

>I didn't mean to say that supply and demand determines the "Fed" rate.
>
>"The interest rate banks charge on loans to the public": surely *this* is
>determined by the law of supply and demand. For example, the public
>buys fewer houses if the interest rate is higher -- can't afford more.

The interest rates that banks charge is a mark up from the what they
have to pay to acquire reserves from the Fed. So interest rates can
rise when demand is high, but they won't fall below some limit
determined by bank profit margins.

However in general, banks are price setters and quantity takers
because the competition among lenders of all types is fierce. Banks
set their rates and the public decides how much it wants to borrow at
those rates. The supply of credit money is limited only by bank
capital, which is generally not a limiting factor.
>
>The Fed wants interest rates to be lower so the demand will be
>higher and get us out of recession -- it is the law of supply and demand
>that makes this work.

True.
>
>A recession causes businesses and the private public to reduce their
>demand for loans. Therefore, in due course, the price of loans must
>fall. In that due course the Fed will observe the falling rate and
>adjust its own rate. (proudly announcing it lowering (controlling) the
>interest rates for the benefit of the public and alleviation of recession)

Not true.

William McChesney Martin, who was Fed chairman from 1951 to 1970,
famously said: "the job of the Fed is the take away the punch bowl
just when the party gets going." That was during the era of low
inflation and high GDP growth rate.

Then came the stagflation era of the 1970s, when both interest rates
and the inflation rate began soaring. In 1979 Volcker started raising
the Fed funds rate still higher to kill the inflation and that threw a
monkey wrench into the economy. But even though the economy was in
severe recession, he found that he had to keep raising interest rates
to historic highs before the inflation rate finally turned around.
Obviously the interest rate was not based on supply and demand then.

The Fed has learned that the lag between a change in monetary policy
and the response of the economy is typically 12 to 18 months. So it
now has its staff modeling the economy with the objective of
projecting ahead by a year or two. That has proven to be only a
modestly reliable guideline, so it is used by Fed as just one of the
inputs to monetary policy decisions. But the forward looking part
remains in its decisions.

The point is that the Fed, for better or for worse, is in the driver's
seat on current interest rates. But it is not responding to current
conditions so much as in projected future economic conditions. In
particular it is concerned with the key macro variables, inflation
rate and unemployment a year or so ahead. The notion that interest
rates are set in response to current supply and demand may be true
locally, but not true in a macro sense.
>
>The mental picture of the Great Central Bank in all its Glory sitting
>at a control panel managing the economy has been well planted in us.
>
It sure isn't my mental picture.
>
>Unfortunately, the economy has its own plans and obeys its own laws.
>The Fed is a good observer and *follows* the laws.
>
Which implies we could replace the Fed with a computer, right?
>
> Mason C now -- if we just could know those laws...

But I thought we understood the law of supply and demand.

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