How Central Banks Control the Money Supply With Interest Rates - YouTube

With the Coronavirus ravaging the global economy, central banks have once upon called upon to

save it using policies such as interest rate cuts, quantitative easing, and helicopter

money.

Now, that sounds great!

But, what does that all mean? Don't worry the Money & Macro channel has got you covered. This video is part of

a series which will cover each of these three instruments in detail.

Let's start with the interest rate. In this video, I will cover how central bankers use the interest rate to control the money supply

Alright, how do central banks control our money?

Let’s make a distinction between two aspects of money.

First there is the price of money, the interest rate, and

Second, there is the total amount of money that is circulating in the economy.

The policies that central banks employ to control both the price and quantity of money

are called: monetary policies.

No surprise there.

These days every time you open a financial newspaper, you will find many headlines concerning

how central bankers conduct monetary policy.

But what does that actually mean?

What do central bankers do when they conduct monetary policy?

The answer to this question is not as straightforward as you would think.

So, let’s take a step back.

What do central banks target?

The price of money or the quantity of money.

Most people would say the quantity of money.

However, this view is hopelessly outdated.

Most modern central banks target the price of money: the interest rate.

Having established this.

There is yet another complication.

Most of you who own money know that there is not one interest rate.

The interest rate that your money yields depends on the type of money that you own.

The two forms of money that you might instinctively think about --coins and notes-- do not pay

any interest at all.

Money in the bank --or bank deposits-- now this might pay out some interest rate.

However, this rate is set by your bank, not by the central bank.

After all, you might be inclined to switch banks to get a better interest rate.

That being said, those of you following the news closely might have noticed that when

central banks increase or decrease their interest rate, quickly your bank will follow suit.

Why is that?

The reason is that the central bank is the bank of bankers.

It provides the same services for banks as banks do for us.

Central banks issue money that only banks can use.

This money is usually called reserves.

Reserves are very important to banks for two reasons.

The first reason is that banks can exchange them for coins and notes with the central

bank.

The second reason is that banks can use reserves to pay each other.

Banks need to pay each other in reserves whenever we are paying someone who has an account with

a different bank than our own.

This gives the central bank some power over commercial banks.

Banks that have too many reserves will try to increase their lending to the economy,

to other banks or will need to hold them at the central bank.

On the other hand, banks that do not have enough reserves will try to attract depositors,

borrow from other banks or will need to borrow reserves from the central bank.

There we have our answer to how the central bank controls the price of money: the interest

rate.

While central banks do not control all interest rates, they do control the most important

rates.

The rate at which banks can can borrow from the central bank and the rate at which banks

can stash their excess reserves at the central bank.

Now, these two rates influence all other interest rates in the economy.

Now let's start with this first one, banks that don't have enough reserves can borrow from the central bank.

But, there are also other options to get extra reserves. This is for example by borrowing from other banks or by attracting depositors.

and you can imagine that if the central bank influences this one rate it will also influence these other two rates.

Similarly, if banks have too many reserves, they can stash them at the central bank for this rate.

and this rate also influences the rate at which they are willing to lend these excess reserves to other banks.

or increase their lending into the broader economy.

Now, there we have it, this is how the central bank interest rates influence all other rates in the economy.

But, now we have only discussed how central bank interest rates influence the price of money, the interest rate.

But, we haven't really discussed yet how the central bank can influence the quantity of money. The total quantity of money available in the economy. That is what we will do next.

If we reflect on the different types of money that we have so far discussed: notes, coins, reserves

and bank deposits, one thing stands out.

Out of these types of money there are only three categories of money for which the central

bank controls the quantity.

What makes things even more interesting is that the central bank cannot control the amount

of money created by commercial banks directly.

Yes, that is right, I said that money was created by commercial banks and that central

banks cannot control the amount they create directly.

That is a whole topic in itself and, therefore, I created a separate movie that discusses

this issue.

You can find it in a pop-up window in the top-right of your screen or if you are on

a tablet, check out the link in the description. That being said,

private bank money creation is very important in modern economies.

So much so that money created by commercial banks is by far the biggest share of the money

supply.

This means that central banks cannot control the most important part of the money supply

directly.

So, does that imply that modern central banks have no control over the money supply whatsoever?

In other words, do bankers have limitless and unchecked control over the quantity of

money circulating in the economy??

Are the popular conspiracy theories about this on YouTube actually correct?

No, not quite.

Here is why.

Yes. Banks create money when they lend to customers.

But, they need demand for these loans.

They need customers to be able to create money.

What is more, there are multiple banks that compete with each other.

If one bank starts lending too much... customers might doubt that they are good for their loans.

At that point the they might first want to try to get some loans from other banks and ultimately they will have no choice but to go the central

bank for a loan.

As you might have guessed.

This means that the central bank can influence the quantity of money by influencing

the price of money: the interest rate. At least, theoretically.

How does this work? Well, let's say that central bank raises the interest rates to a very high level

this will mean that all other rates in the economy will have to follow. So, all other banks will also increase rates to a very high level.

Now, if you have that, only risky borrowers will be left in the economy and want to borrow from banks.

Now banks know this and so it is in their interest to scale back lending. In other words, they will not create as much money as they would in an environment where interest rates are quite low.

Conversely, if the central bank interest rate is very low, commercial banks might feel confident

to go on a lending spree.

This is it!

… decreasing or increasing the interest rate.

That is what central bankers generally mean if they talk about monetary policy.

By increasing the central bank interest rate, banks are discouraged from making loans and,

in the process, they are discouraged from creating new money.

Therefore, they call this monetary policy tightening.

And, the other way around, by lowering the interest rate, the central bank can encourage

bank lending, increasing money creation.

This is what they call monetary policy loosening.

Now, you might be wondering.

When does the central bank increase or decrease the interest rate?

In other words, what is the goal of monetary policy?

The answer is, for almost all central banks, to stabilize the general price level in the

economy.

To be more precise, they want to stabilize the change in the price level in the economy.

Better known as inflation.

Central bankers like stable inflation.

So, it makes sense that most central banks use monetary policy to control inflation.

This practice is what they call inflation targeting.

Usually, central banks set an inflation target at around 2%.

Why 2% you may ask?

This number might seem a bit arbitrary,….. and...... while it is still a bit

arbitrary, there is some thinking behind it.

In general central bankers believe that a bit of inflation is good because it helps

borrowers pay off their debt and because it motivates people to spend their money as it

is getting worth less over time if they hold it.

To achieve their 2% target, central bankers will fiddle with the interest rate to get

inflation near that target of 2%.

When inflation is too high, central banks will often increase the interest rate and

when inflation is too low, they will tend to lower interest rates.

The general idea behind how this works is the following.

The central bank believes that inflation depends on the level of unemployment in the economy.

Low unemployment is believed to lead to inflation whereas high unemployment is believed to lead

to deflation...

Why is that?

Most central bankers believe that, if unemployment is really low, workers will demand higher

wages.

So, on average, wages will increase.

Companies who see their profit levels then shrink will then increase the prices that they charge

for their goods.

Because all companies will do it at the same time, the overall price level will rise.

That is what we call that inflation!

So, how does the interest rate matter for all of this?

Well, as mentioned earlier in the video, the interest rate determines how attractive

it is for banks to lend out money.

A low interest rate will tend to boost investment and consumption which means the economy performing well and

that unemployment is low.

But, if the economy is performing too well, with an extremely tight labour market,

inflation is very likely to be above target.

If this is the case, the central bank should increase the interest rate.

This will slow down lending, which will in turn slow down consumption and investment

and cool down the labour market.

Wages are now likely to stop increasing and so will prices.

So, by increasing the interest rate, the central bank has cooled down the economy and prevented

inflation from getting out of control.

In the opposite case, in which the economy is underperforming, unemployment is high,

and inflation will tend to be low.

Maybe there is even deflation.

The central bank, following their theory, should then decrease interest rates.

This will increase investment, consumption which will increase economic growth and inflation.

That is the story that most central bankers have in mind when they determine whether the

interest rate should go up or down.

But, in practice, as citizens of Europe, the U.S. and Japan have experienced over the last decade,

it is questionable if this story is actually true.

In these regions central banks interest rates have been super low for a long time, but inflation

has hardly moved.

Especially, the bank of Japan and the European central bank just don’t seem to get their

respective inflation numbers to target.

So, can central bankers really control the money both the price and quantity of money in our economy just by tinkering with

their interest rates.

There is really no scientific consensus on this.

But, I do know that there is a lot more to this.

As a result of this uncertainty, central bankers have started to experiment with new monetary

policies such as quantitative easing and helicopter money.

These will be discussed in the next episodes.

But for now, this was it.

Now you know how the central bank at least tries to controls our money.

And this happens through them setting their interest rate and this influences all these other interest rates.

And their theory goes that this will then influence the quantity of money circulating in the economy

and finally this will have a big impact on inflation.

and since central banks have a target inflation of around 2%,

they will generally try to increase the interest if inflation is above target. To slow down the economy somewhat.

and decrease inflation.

And they will try to decrease interest rates if inflation is below target, at least for a long time.

Now in practice, this is much more difficult than it is in this simple theory and I would like to dive into much more detail in future videos.

But for now, these were the basics, on the Money & Macro channel.

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