Thick bloke asks worlds hardest question on macroeconomics

March 21, 2007 10:43 AM

Interest rates and Inflation, does anyone actually understand it?

I hold a degree in Business, I have read the Wealth of nations by Adam Smith, but I still don't have the faintest clue how interests and inflation really works.

Being someone who believes in freemarkets I suspect its due to mindless interference by government, but if someone could explain to me how it all works i would appreciate it, cos its been bugging me since highschool.

Mainly if someone could tell me how interest rates are actually set that would help, I know in england, interest rates are set by the bank of england. I don't understand this because if their a bank, they want the highest interest rate possible for their customers, so they are bias.

So my questions are:

1.) How do they actually enforce what they decide? sure they might say that the interest rate will be 5%, but how do they make the markets follow that?

2.) Why print money? for reasons other than replacing notes that get worn out.. If you don't print extra money you don't get inflation, so why would you want to?

3.) What would happen if they didn't set interest rates and didn't print extra money?

posted by complience to Work & Money (26 answers total)

I seriously recommend getting a macroeconomics textbook and reading the relevant chapters on monetary economics and central banks.

Greg Mankiw's "Macroeconomics" is a good, lightweight introduction to macro in general. Frederic Mishkin's "Economics of Money, Banking and Financial Markets" is a bit more advanced and more specific to your questions. These are easy reading compared to Adam Smith. It's great if you're comfortable with the maths, but if not you can skip the equations and still understand the explanations.

There's tons of material on the web about this — 99.9% of it is crap, written by people who have strong opinions and no knowledge. Even the good stuff tends to be frothy, simplistic "popular economics" stuff which raises more questions than it answers.

To answer your questions, you need to understand the role of central banks and some basics of the monetary transmission mechanism. These will be better explained by macroeconomics textbook writers than random folks on the web.

To correct a couple of points:
I know in england, interest rates are set by the bank of england

UK interest rates are set by the independent Monetary Policy Committee (MPC) of the Bank of England. The BoE is not a bank like Bank of America or Citibank. It's a Central Bank like the Federal Reserve, or the European Central Bank which sets interest rates for the Euro area. It is the 'government's banker'.
posted by Aloysius Bear at 11:03 AM on March 21, 2007

I know that the interest rate is basically how much the Fed charges banks to borrow money. If banks have to pay a lot to get the cash, they pass that onto the borrower (customer). If people can't afford to borrow cash because the interest rate is too high, then there will be less cash in circulation = decrease in inflation. At least that's how I remember it from Economics 101. I may be totally off on this one.
posted by HotPatatta at 11:04 AM on March 21, 2007

Let's clear up a couple of problems right here at the outset. Wealth of Nations, though a wonderful text, doesn't address the questions of "central banking or "monetary policy." As a central bank, the Bank of England's responsibility is not to customers or shareholders directly; rather, it exists to safeguard the monetary stability of the British currency and the financial stability of the British markets. You are correct in assuming that the existence and function of a central bank is in direct contravention to the idea of laissez-faire.

As a matter of fact, I tell you what. Read the three Wikipedia articles I linked. If that doesn't clear this question up for you, come back and say what still doesn't make sense and we'll work on it some more.
posted by ikkyu2 at 11:06 AM on March 21, 2007

You used the term "bloke", so I assume you're British. My answer may not be relevant, as I am American and don't know anything about the monetary policy of England.
posted by HotPatatta at 11:06 AM on March 21, 2007

Please read this article at wikipedia about inflation:
http://en.wikipedia.org/wiki/Inflation
Then this one on monetary policy:
http://en.wikipedia.org/wiki/Monetary_policy
they explain things much better than I can
posted by defcom1 at 11:08 AM on March 21, 2007

Response by poster: well reading the first paragraph on the wiki for central banks.. im already confused.

"A central bank's primary responsibility is to maintain the stability of the national currency and money supply"

I don't understand this, if you don't print any extra money a currency will be stable anyway, and supply more or less takes care of its self so long as you just replace old notes with new ones.

Why don't commercial banks issue their own currency? I wouldn't mind having a wallet full of HSBC dollars?
posted by complience at 11:13 AM on March 21, 2007

Please read the entire article before posting follow-up questions.

Oh, and most money is never printed. It only exists as numbers on various computers.
posted by defcom1 at 11:22 AM on March 21, 2007

I don't understand this, if you don't print any extra money a currency will be stable anyway

No, the "money supply" doesn't just mean 'notes and coins'.

This is why Wikipedia is a bad way to learn about a topic like this. A textbook will define its terms first, explaining what the term "money supply" actually means.

Why don't commercial banks issue their own currency?

There are laws against this. Can you imagine a country having several different currencies? What would HSBC dollars would be worth in terms of Citibank dollars? Maintaining a stable, consistent currency is one of the primary functions of the state.

As an aside, in Scotland banknotes are in fact 'issued' by commercial banks (Bank of Scotland, Clydesdale Bank etc). But the state still maintains complete control; the fact the banknotes happen to bear the logos of commercial banks is a historical accident with no real day-to-day significance.
posted by Aloysius Bear at 11:25 AM on March 21, 2007

Seconding a macro textbook. Your second and third questions, unfortunately, are difficult to answer without considerable background, which is what a text will provide. That said, the Wikipedia link on central banking answers your first question, if you'll take a look a bit further down.
posted by smorange at 11:43 AM on March 21, 2007

I don't understand this, if you don't print any extra money a currency will be stable anyway

No, the "money supply" doesn't just mean 'notes and coins'.

"Printing money" doesn't always literally mean "printing money."

And, DU, plenty of educated people have believed that Inflation is Always and Everywhere a Monetary Phenomenon.
posted by Kwantsar at 11:57 AM on March 21, 2007

The US had, for a time, private banks printing "private" money. Damn Alexander Hamilton for that. But yes, that's a silly system, which is basically why Hamilton won in creating the Bank of the U.S.
posted by zpousman at 12:22 PM on March 21, 2007

There are laws against this. Can you imagine a country having several different currencies? What would HSBC dollars would be worth in terms of Citibank dollars? Maintaining a stable, consistent currency is one of the primary functions of the state.

We're getting into a politically fraught issue here, but historically private currencies have existed--in the mid-19th century in the US, for example. The drawbacks are largely as Aloysius Bear notes above: lack of stability of the issuer, lack of widespread acceptance, etc.

That said, there are some possible positives to a private currency system, since central banks can be subject to political pressures that might not affect a private issuer. Here are some interesting thoughts on the subject.

(warning: searching on the term "private currency" will mostly bring back agitated screeds about how the Fed is controlled by the Jews, and the like.)
posted by Chrysostom at 12:32 PM on March 21, 2007

Try Secrets of the Temple.
Great history of the Fed, with explanations of all these topics in contexts that make things clear.
posted by jma at 1:48 PM on March 21, 2007

Secrets of the Temple: This ground-breaking best-seller reveals for the first time how the mighty and mysterious Federal Reserve operates -- and how it manipulated and transformed both the American economy and the world's during recent crucial decades ... Secrets of the Temple takes us inside the government institution that is in some ways more secretive than the CIA and more powerful than the President or Congress.

Maybe read this after reading a few chapters of a macro textbook. It sounds rather more like a conspiracy theory than an objective explanation of the economic role of a central bank. I doubt this kind of book explains in a clear, unbiased way how the Fed's control of the interest rate impacts inflation.

You wouldn't read a Michael Moore or Rush Limbaugh book to understand the American political system, so don't read this Greider book before understanding the economic system.
posted by Aloysius Bear at 2:03 PM on March 21, 2007

More than a Macro textbook, you need a 100-level money and banking textbook, and quite frankly, I am shocked that you got through business school without reading one.

Money supply changes because most money is actually created through credit. This is called M1 money, which is all the cash as well as all the bank accounts which are not subject to withdrawl restrictions(meaning checking accounds) For every dollar bill that has ever been deposited in a bank, there are a few thousand or more dollars on people's checks and bank statements representing loans made on that dollar.

This is the real magic of banks. The money in your checking account has already been loaned out to someone who has deposited it in a bank, which has loaned it out to someone else, who has deposited it in another bank, who loaned it out to... and so on.

That is why money supply is volatile, and subject to something called "Velocity of Money".

Basically, the way that central banks control interest rates is by buying and selling treasuries to influence overnight interest rates between banks, which use this overnight market to meet reserve requirements. If at the end of the day they have too much cash lying around, they loan it out through this market. If they don't have enough cash and will be below their required reserve, they borrow it.

Central banks, which control currency, act within a very specific market(That overnight interbank loan market I mentioned) to control this one basic market interest rate. Everything else flows from that.

In the US, the FOMC, or Federal Reserve Open Market Committee meets and decides on a target interest rate. Then the Federal Reserve Bank of New York monitors liquidity in the overnight market. If the rate goes above their target, they buy lots of Government Bonds from the banks, taking the bonds and giving them cash, increasing the supply of money, lowering the interest rate. When the rate slips below target, they sell lots of bonds, taking cash out of circulation, so that the interest rate rises.

The NY Fed does this all day, every day, and rarely does the rate get more than a few basis points away from their target.
posted by OldReliable at 2:06 PM on March 21, 2007

Bank of England has How Monetary Policy Works (complete with diagram)
posted by TrashyRambo at 2:11 PM on March 21, 2007

Printing money is a somewhat surreptitious way of squeezing a bit more tax money out of the populace. Printing a little is tolerated; printing a lot would raise eyebrows and hackles.
posted by iconjack at 2:13 PM on March 21, 2007

IANAE, and I agree that you should read a textbook. Only an idiot would attempt to answer these complicated questions in a Metafilter comment. So...

1.) How do they actually enforce what they decide? sure they might say that the interest rate will be 5%, but how do they make the markets follow that?
They don't enforce all rates. They set one or a few rates (varies from country to country). They lend out money to normal banks under some circumstances. It's not that hard to lend out money when you're allowed to print it.

2.) Why print money? for reasons other than replacing notes that get worn out.. If you don't print extra money you don't get inflation, so why would you want to?
Several reasons.
A. As the economy and the population grows, you need to increase the amount of money in the system.
B. Controlling inflation is tricky, and if you try too hard you get deflation, which is also bad. Some think it's safer to allow a little bit of inflation rather than aim for zero and risk tipping into deflation
C. The measures you take to control inflation have other negative consequences. Limiting the money supply means it's harder to get money for investment, companies might go bust because they can't borrow to get over a temporary bad spell, unemployment tends to go up, etc.

3.) What would happen if they didn't set interest rates and didn't print extra money?
If they didn't print money, when you went into Starbucks you'd have to fight bitterly to get hold of a penny, and then buy six cappucinos because you can't get change.

If they didn't set interest rates, they might use fiscal policy instead of monetary policy to stimulate/cool down the economy. So, they'd probably change the tax rate every month, and give you a big rebate if they thought the economy needed more money around.

Or, we could just learn to live with massive boom/bust cycles. Or maybe the anarcho-capitalists are right and everything would somehow self-organize itself once we got used to it. Basically: I haven't a clue.
posted by TheophileEscargot at 2:17 PM on March 21, 2007

Response by poster: so i now understand why we don't have private money...

the government don't allow it.

but im still confused as too why government like to cause inflation by printing money.?
posted by complience at 2:25 PM on March 21, 2007

The government likes to give people credit. If credit is easy to get people are going to be more risky in their investments. If they are more risky in their investments it in theory increases new business and new technologies and the economy grows. It is a rather complex system.

As an indirect result of of this you will get too many dollars chasing too few goods. If this is slight, it is a little inflation and not really a big deal as the economy can cope with this (slight pay bumps every year, etc.). If credit is too easy to get, investment decisions get sloppy and money is wasted and inflation happens. A lot of it also is trust. If people believe their money is worth nothing they would be more apt to spend $100 on a pen if they think that the $100 will be worth nothing tomorrow.

It is debatable how much of a role the central bank plays. Right now they are rather loose with credit, the markets are being wise in investment (apparently) and inflation is manageable and low. If something happens to upset this system (say industry shifts like it did in the late 70s) and the economy is unable to react, things kind of go out of whack. A lot of it is theory, and a lot of it is bunk theory. I've read countless papers looking at inflation indicators (a basked of basic goods, energy prices, etc.) and there are so-called trailing indicators and a whole host of things you can test to see if they have some sort of statistical significance.

Basically inflation is not some set number, it is nebulous but most of us can agree on a general area of inflation. If anything setting interest rates is a skill, it is far from an exact science.
posted by geoff. at 2:53 PM on March 21, 2007

I don't understand this, if you don't print any extra money a currency will be stable anyway, and supply more or less takes care of its self so long as you just replace old notes with new ones.

Your recipe for currency stability is correct. But is this the best way?

No, because more people are being born all the time, and businesses are expanding, and land previously fallow is being built upon and made more productive. If there is not a way to inject more money in the economy, soon there is not enough money for everyone who wants to use money. Markets collapse; the economy enters a recurrent boom-and-bust cycle, you have a system with a stable currency but with monetary instability built in.

You are rapidly approaching the point in your repeated inquiries where your simple questions have complicated and controversial answers. I agree with most of the above posters who suggested an introductory economics textbook.
posted by ikkyu2 at 3:22 PM on March 21, 2007

I don't understand this, if you don't print any extra money a currency will be stable anyway, and supply more or less takes care of its self so long as you just replace old notes with new ones.

Your recipe for currency stability is correct.

Not exactly, because "how much currency is in circulation" isn't the only important thing. Another important thing is how often it changes hands.

Let's make up an example. There's an island with no outside contact and five people. They each have $100. Since there's no outside contact, the amount of money in circulation isn't changing.

So, on this island, one person hunts for meat and sells it to the others, one person grows vegetables to sell, one person fishes, one person makes clothes and mends old ones, and one person builds and repairs shelters. And, every week, the hunter sells $40 of meat, the vegetable person sells $40 of vegetables, the fisher sells $40 of fish, and the and the clothes and shelter people make $40 each from their services. So, in this microeconomy, $200 changes hands a week.

But then, the person who grows vegetables increases their prices (maybe there was a drought or something, and they're suddenly having to sell from their stockpile). And everybody needs vegetables or they'll have vitamin deficiencies, so they have to buy them; they can't just hold out and make the vegetable grower sell them at the old price. So, the vegetable grower is now selling $60 of vegetables a week ($15 per person instead of $10 per person). However, the other people realize that if things continue like this, they'll go broke, because they're only making $40 a week, but they're spending $45 ($10+$10+10+$15). So they raise their prices, until they're all making $60 a week (they may not do it all at once, but that's where the equilibrium is. If they just raise prices enough so that they're making $45 a week, oops, suddenly they're spending more than $45 (because everyone else's prices went up) so they have to raise prices again).

Suddenly, there's $300 changing hands a week instead of $200: Inflation just occurred, even though the amount of currency in circulation is constant. Everyone's spending more and getting the same goods and services.

Can you see how keeping the currency supply constant won't prevent inflation?

(That was an example of "cost push" inflation, where an increase in the cost of one thing increases the cost of everything.)

3.) What would happen if they didn't set interest rates and didn't print extra money?

Inflation would still occur, because it has causes other than changes in interest rates and more money being printed.
posted by Many bubbles at 5:29 PM on March 21, 2007 [4 favorites]

One reason governments want some inflation is that it is sometimes necessary for the real wage level in a particular job or industry to fall. It is very hard, however, to get workers to agree to pay cuts. Keeping pay flat, at a time of moderate inflation, achieves the same effect.

I too recommend Mankiw's text. While Adam Smith is interesting in a 'history of ideas' kind of way, it really isn't the way to learn about contemporary economics.
posted by sindark at 7:29 PM on March 21, 2007

Inflation would still occur if the fed decided to print no new currency. Inflation can be caused by a number of things, such as an increase in the price of oil. If the price of an extremely important input to an economy increases, prices across the board will increase. Prices across the board increasing = inflation.

"How interests rates are actually set" is a rather complicated question, but basically, the central bank of a country (in our case the Federal Reserve, or more specifically makes what are called "open market transactions" whereby they either buy or sell securities--for simplification, let's say they're buying and selling simple treasury bonds--and in the process either putting more currency into the economy (if they're buying bonds) or taking currency out of the economy (if they're selling bonds). This change in the amount of currency, by some complex factors that don't really need to be discussed, essentially cause changes in the market supply and demand for currency, which in turn changes prices.

This is all of course very simplified, rough and even not-so-accurate in some cases but it explains the situation in theory.
posted by jckll at 8:37 PM on March 21, 2007

Response by poster: This is a good video.

http://www.youtube.com/watch?v=A4kxTkhwR_Q
posted by complience at 8:53 AM on March 26, 2007

Response by poster: lots of good answers.. i now think I do more or less understand why governments print money, basicly its cos they're stupid but have good intentions to slow inflation.

I see now what I really don't understand is inflation. One of the examples given was the one on the island.. where a draught causes the price of vegetables to go up.

Great! that makes perfect sense... only it doesn't.

because the following year might be a bumper harvest, and so this would cause deflation and cancel out the inflation from the previous year.. problem sloved.. no need to print money.
posted by complience at 5:43 AM on March 30, 2007