Money Supply, Inflation, and Nominal Interest Rates
I was browsing through the podcasts over at EconTalk and listened to a great discussion with Tyler Cowen from Marginal Revolution. The host, Russ Roberts, brought up an interesting point about a tension that exists when the Fed increases the money supply in order to lower interest rates.
We hear in the news everyday about how "the Fed lowered interest rates," but most people don't really understand what this means. There are two rates that the Fed "sets." One is the discount rate and the other is the fed funds rate. The discount rate refers to the rate that the Fed charges member banks when they borrow reserves from it. Cowen points out that changes in the discount rate are not really significant because if a bank is distressed and needs to borrow money from the Fed, the real problem is going to be the alarms that will be raised regarding the health of that bank. This is a much greater cost than the interest the member bank will have to pay the Fed. So when the Fed changes the discount rate, it does not have much of an effect.
The othe rate the Fed sets is the Federal Funds rate which is the rate at which banks lend balances to other banks. The way the Fed "sets" this rate is by buying T-Bills and other government securities using newly printed money, thereby increasing the supply of loanable funds. It is simply a matter of supply and demand. If the supply of money goes up, then the interest rates, which are the "price" of money goes down.
The interesting tension that Roberts points out is that as the Fed pumps more and more money into the system, people begin to expect inflation. If people expected, say, 10% inflation a year from today, then no one will lend for less than 10%. The interesting point here is that the Fed, in the short-run, can lower short-term real rates if it pumps money into the system once, or even a few times. But eventually, if the Fed continues to inject more liquidity, nominal interest rates will rise because of the expectations of inflation.
I think this is an interesting point to consider and I don't think most people understand it this way. It's not readily apparent that when the Fed takes actions to lower interest rates, nominal interest rates can actually rise as lenders demand an inflation premium on the funds they lend.
Cowen also pointed out that even though the Fed has lowered interest rates, this doesn't necessarily have any real effect on business activity. There is no guarantee as to what banks will do with the money. If the money simply sits there or funds projects that would have been completed anyways, then there isn't necessarily an increase in business investment.
These points are fairly basic, but important nonetheless.