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How are interest rates set?

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jimaustri123 Posted: Mon, Jan 14 2013 2:50 AM

Hi,

I have often wondered exactly what the factors involved in interest rate 'fixing' are.

I hear the central bankers set interest rates at artificially low levels and have been holding them there but how are they able to do this? Just trying to think through how this actually occurs.

When the monetary policy committee come out of a meeting having agreed that the interest rate should be changed by a half a percent, for example, what actually transpires to make that a reality?

 

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Wheylous replied on Mon, Jan 14 2013 9:24 AM

A change in reserve ratio is seldom used but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits.A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect. (Read more on this subject in Breaking Down The Fed Model.)

The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa). As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate that it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

Open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. Note that the terms "purchase" and "sell" refer to actions of the Fed, not the public. For example, an open-market purchase means the Fed is buying but the public is selling. Actually, the Fed carries out open-market operations only with the nation's largest securities dealers and banks, and not with the general public. In the case of an open-market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself. When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

From http://www.investopedia.com/articles/08/fight-recession.asp#axzz2HxkP5coe

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A change in reserve ratio is seldom used but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits.A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect. (Read more on this subject in Breaking Down The Fed Model.)

So, if I understand correctly, a reserve ratio of 1:1 means 100% of a deposit is required to be kept in reserve and and reserve ratio of 1:10 would be a decrease in the ratio at 10%, with $900 being allowed to be created(and loaned out) from a $100 deposit.

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Yeah, kind of.  Here's some vids that may help:

How Fractional Reserve Banking Increases Inflation

Money as Debt (I and II)

Note: Paul Grignon's animated presentation of "Money as Debt" and the sequel "Money as Debt 2" tell in very simple and effective graphic terms what money is and how it is being created. The "solutions" presented, however, are false ones. [For more on this, see here]

 

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I watched that franctional reserve youtube video and it seems to me that this is a case of accounting-by-decree.

What interests me is how central bankers justify the need for fractional reserve banking. Why do they say it is necessary? What do they say would happen without it?

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Hehe.  You've just opened a much bigger can of worms than you might realize.  See here:

 

Fractional & full reserve banking & the Federal Reserve

and just for good measure, I'll include:

Fiat money advocates, aka "Greenbackers"

 

from The Ultimate Beginner meta-thread

 

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Hehe.  You've just opened a much bigger can of worms than you might realize.  See here:

Okay, I'm aware of this debate but have not set aside the time to get to the bottom of it yet. For the time being, I will put it to one side. I suppose the important thing about the reserve ratio is that it is not something which sets rates directly but rather, through inflation of the money supply, renders existing market interest rates too low and hence those rates must adjust - just like other market prices. Is that more or less correct? (i.e. prices must increase to compensate for a loss of purchasing power)

The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa). As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate that it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

This 'discount rate', as mentioned, is a direct setting of rates in the market. What interests me here is under what circumstances does it suit central bankers to raise interest rates? I've heard many commentators e.g. Peter Schiff, saying - in response to their critics - things seem okay now but just wait for interest rates to go up... then you are going to see real problems. Which of the three ways mentioned by Wheylous(reserve ratios, discount rates and open market operations) are being referred to by these commentators? And what would be the driver for the central bank to change tack?

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Neodoxy replied on Fri, Jan 25 2013 12:48 PM

"I suppose the important thing about the reserve ratio is that it is not something which sets rates directly but rather, through inflation of the money supply, renders existing market interest rates too low and hence those rates must adjust - just like other market prices."

Something that's extremely important to remember is that interest rates are indeed not "set", instead the interest rate and the supply of loanable funds are both set by market interactions. It is indeed a market price, however it is highly influenced by the government. The government influences interest rates not through price settings, but instead by manipulating market supply (it also influences demand but that's another issue). By manipulating the reserve requirement the federal government increases the supply of money available on the loan market because now banks can increase the amount of money they offer at any increase in bank savings.

I remember I once had a brief argument with the youtube poster "Shane Killan" who was arguing that the reason the economy hadn't recovered is because the FED had set interest rates too low and so people weren't investing. This is an absolutely absurd notion because if that were the case then interest rates would instantly rise until supply and demand equilibrated. You can argue that the fed decreasing interest rates indirectly shifts demand to the left and decreases investment, but that's something of a separate issue. If people weren't investing because interest rates were too low then the market would drive up interest rates until they did, the FED cannot stop that, it can only shift the supply curve to the right, but this works through real (although unbacked and possibly unstable) investment realization.

It's essential to understand that markets don't achieve equilibrium instantly. Money is a good, a special type of good, but it is still subject to supply and demand.

"What interests me here is under what circumstances does it suit central bankers to raise interest rates?"

From the purely textbook point of view it is done to decrease inflation. If inflation was not a result of decreasing the interest rate beyond a certain point (magnified by the fact that much of this drop is due to an increase in the money supply) then there would be no downside to decreasing the interest rate to practically nothing infinitely (from the mainstream standpoint). For instance during the early 80's the FED raised interest rates dramatically to the point where a very severe recession was induced. This was done to end that massive stagflation of the previous decade where you were seeing annual inflation rates of about 8 percent.

What the FED is using to manipulate interest rates in our day is actually primarily none of the ones that Wheylous outlined, instead it is a fourth method "Quantitative Easing". The reason why this will eventually lead to massive inflation is because of the dramatic increase in the money supply which has occurred will eventually come into full circulation and will affect prices much more during full employment. In a recession where demand is low an increase in the money supply need not produce too much inflation. When the recession ends (although possibly before) resources are more or less employed on a mass scale so the increase in money just leads to increases in prices, NOT more employment. This leads to massive inflation and the only way to curtail this is through increasing interest rates and decreasing aggregate demand.

At last those coming came and they never looked back With blinding stars in their eyes but all they saw was black...
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jimaustri123:
This 'discount rate', as mentioned, is a direct setting of rates in the market. What interests me here is under what circumstances does it suit central bankers to raise interest rates? I've heard many commentators e.g. Peter Schiff, saying - in response to their critics - things seem okay now but just wait for interest rates to go up... then you are going to see real problems. Which of the three ways mentioned by Wheylous(reserve ratios, discount rates and open market operations) are being referred to by these commentators? And what would be the driver for the central bank to change tack?

I discuss this here.

 

from *Interest rate threads*

in The Ultimate Beginner meta-thread

 

To further illustrate at least part of what Neodoxy is saying, see here:

 

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