Hi I have a question about the Federal Reserve and the manipulation of interest rates. I understand that the problem with the central bank is that it will either push interest rates too high or too low which affects the availability of credit that flows into the economy. My question is this: Why don't we adopt a policy where the interest rate remains at (let's say) 5% indefinitely? Would this encourage a large amount of savings as well as ensure only good investments by banks? Would the knowledge that the rates are static be a benefit since there is no chance it would go up or down? What am i missing?
What would happen if we set the price potatoes to $1 per kilo?
We have a price system for a reason. It is an information transmitter. In this case, the interest rate reflects time preference and real savings. Any tampering with it it bound to cause trouble.
Irish Liberty Forum
It's a bit more complicated than that. There are more problems with the central bank than just interest rate manipulation. Inflation of the money supply through credit expansion is also a problem. To be fair, this is just the other side of the coin though, as this is the way in which the Fed lowers the interest rate.
As to why a "static" interest rate isn't the solution: When the interest rate is too high or too low, then it is too high or low in relation to something. That something is the natural rate of interest, also known as the interest rate that would appear if determined by the market. The problem with having the Fed maintain a fixed interest rate is that even though it would be fixed, it would certainly still be too low or too high in relation to what it would have been without their interference, and would therefore still cause problems. Even if the Fed by some freak accident managed to "hit" the correct interest rate, this correct interest rate is always changing as people's preferences are always changing.
You also need to realize that the Fed doesn't set interest rates per se. They set targets for the federal funds rate (the rate at which banks borrow from each other) through open market operations.. ie - affecting the money supply by trading bonds.
I should add that banks can borrow from the Fed directly (at the discount rate) which is set by the fed, but banks raise most of their capital through interbank borrowing, so the federal funds target rate is the more important number.
If this were to happen, and in reality the interest rate would have been 7% this essentially creates forced savings, and as such all the usual features of the business cycle.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
If the market set interest rates would different banks all have slightly different rates at different times?
James Greene:If the market set interest rates would different banks all have slightly different rates at different times?
Yes. Interest rates would be competetive, like prices.