Ron Paul and other individuals talk about how the market should set interest rates, but how is that possible?
Supply and demand, like any price. Banks will raise interest rates offered, and charged, until there is a rough equilibrium between supply of lendable funds and demand for them.
Do you understand how it is done now? In principle it would be done the same way as now. The only difference would be that there is no central bank changing the amount of base money through OMOs (Open Market Operation, which means selling/buying treasury bonds). Through OMO’s they can influence the overnight interest rate, which is the interest rate banks charge each other for borrowing reserve money (that is money held at an account at the fed) they need to fulfill the legal reserve requirements.
The more scarce reserve money (base money) is the higher the overnight interest rate. If there is an excess of reserve money, than the overnight interest rate falls to zero. At this moment there is a huge amount of excess reserves in the US banking system. The only reason the FED can say it keeps the overnight interest rate at 0-0.25% is by paying banks interest of 0.25% on their reserves.
So what you see is not that the FED mandates banks to charge the desired overnight interest rate, it merely changes the market conditions (base money supply) so long until banks ask for exactly the interest rate those FED technocrats deem is right.
This overnight interest rate determines at which rate it is profitable for banks to lend money to its customers. In a free banking system there would just not be a legally defined monopoly money and institution that could influence/distort the market. Then the banks could only acquire funds for lending directly in the market and depending on how scarce those funds are the interest rate that is profitable for banks to lend is determined.
Through OMO’s they can influence the overnight interest rate
The impression I got from my Econ class is that they don’t really use OMOs that much but rather focus more on the discount rate.
Quite the opposite, Wheylous.
My research told me the opposite. The discount rate only is used in rare occasions, since it is kind of a stigmata for banks who use it, because this could indicate that the bank is in trouble. Maybe some one else can elaborate a bit on this..?
Open Market Operations is the primary tool used to influence monetary policy. As you said, the discount rate has historically been used less. However, after the recent crisis, it was used to a far greater extent. If I’m not mistaken, when the Fed bails out institutions it is basically lending liquidity at extremely low-interest thru the discount window.
I have a thread about this. Basically, it’s that the market determines interest rates, but the Fed distorts the market. See John James’ reply to my thread.
The Fed really can’t very easily reduce the money supply if I’m not mistaken. They’re an inherently inflationary institution. That makes sense because the Fed is there to be a safeguard for fractional reserve banking.
Is there a book that goes into this in more detail (regarding the mechanics of fiddling with the interest rates, et cetera)?
Before I ever read that book I read an article by Robert Murphy that put it about as easily as it could be put. Took me a while to find it because the explanation was somewhat tangential to the article, but here it is.
I appreciate the effort- thanks! I’d imagine that The Creature from Jekyll Island would help as well?