I still get confused trying to explain the interest rate to other individuals (obviously stemming from my lack of know). For example, , in Introduction to Austrian Economics says that
“We have seen already that the interest rate reflects the ratio of present goods valuation to future goods valuation. If there is a shift toward a greater preference of present goods over future goods, then the interest rate increases correspondingly, reflecting the greater discount of future goods.”… “It is important to stress that the market rate of interest provides a signal that indicates the extent to which capital goods production may be undertaken without frustrating the demand for consumer goods.”
–Do understand correctly that for me to forego my current consumption, the interest rate paid to me for my current savings must be higher or the interest rate loaned to me must be lower?
–And then i get confused about why we speak of interest rates being paid out to me. Doesn’t this implicitly assume fractional reserve banking? I know FRB is not anti-Austrian, but am i right in that assumption that interest paid via banks would not take place in a full reserve banking system (unless they are time deposits).
Jeremiah, I read your questions, but I’m having trouble understanding exactly what it is that is confusing you. Are you looking for a discussion about the nature of interest rates, time preference, and subjective value scales? I was going to phrase an answer along these lines, but thought I should clarify the question first.
Interest is very simple. Taylor is assuming that a bank will get its money from people walking in off the street. But if the people on the street want to spend their money on cakes, what will draw them to the bank to deposit their money instead? Answer: Up the interest being paid by the bank to the depositor, until the man on the street hearing about the high interest rate is willing to not eat his cake now, but eat it with interest later.
So the first of the two options in your first q is the right one.
The problem with FRB exists even if the bank gave no interest at all to the man in the street. They take his money and lend it to Bill Gates for three years, at the same time promising to give it back to the man in the street any time he wants it. Which of course they cannot do, since they lent it all to Gates.
here is how it would look without FRB. Young Bill Gates hits on some brilliant idea. If he scrapes the money together and builds his better mousetrap, he estimates he will get $110 for very dollar he invested. So he goes to the bank and says he wants a loan and is willing to pay 5% interest. The bank, however, doesn’t have any money. So it advertises that if the man in the street will deposit his money with them for say three years [enough time for Gates to pay back his loan] they will give said man on the street 3% interest.
As far as bank loans are concerned, time deposits can earn interest so no FRB scheme is necessary. However, your question raises the suspicion that you are confused about something much more fundamental. The contribution of the loans market on the market rate of interest is much smaller then most people realize. The rate of interest is determined by all forms of investments and financial instruments. So most interest is earned not via banks.
There is nothing inherently fractional about interest rates. I have a sneaking suspicion that you’ve watched Paul Grignon’s “Money as Debt” video. If you have, you need to perform a disk format on that partition of your brain and perhaps securely wipe it a few times with PGP desktop. After you’re done thoroughly deleting everything related to the “Money as Debt” nonsense, go read chapter VI from Rothbard’s Mystery of Banking. The key issue is that in a natural money economy, the interest on a loan and the money supply are independent variables. There is some interplay between the aggregate interest rate (pure rate of interest or PRI) and the money supply which Hulsmann has recently elucidated but that is a pedantic point.
When the Man On The Street demands his money, the FR Bank need only borrow money from the Fed to satisfy MOTS’s demand (or, more correctly, enough money to replenish their reserve requirement for Gates’s loan.) The Fed happily creates the new money, and it is only at this point that Fractional Reserve Banking becomes inflationary.
Edit:
Also, it is not true that “…they lent it all to Gates.”
Assuming a reserve ratio of 10%, then, at most, they lent 90% of it to Gates, and kept 10%.
That depends on your definition of inflationary. But what happens when the bank pyramids multiple loans on top of the original deposit? Do you consider that inflationary according to your own definition?
All you say may be true, I don’t claim intimate knowledge of the subject.
I did know about the 90% part, but gave a simplified example that would make clear the point that even at zero interest all the “challenges” of FRB are there.
Inflationary: causing an increase in the supply of money.
What do you mean by “pyramids multiple loans on top of the original deposit”?
You mean, like in this wiki explanation? If yes, then no, it’s not inflationary, according to my definition, because this process has not caused an increase in the supply of money. No new money has been introduced.[color=red]*[/color]
[color=red]*[/color]Until depositors deplete their account balances, at which point the bank must borrow, from the Fed, to meet the reserve requirement. Only then is new money created…created by the Fed.
Edit:
But, I think I get what you mean now by “That depends on your definition of inflationary.” If “inflation” is defined as “an increase in the sum total of the bank balance $ amounts in a system,” then yes, it is inflationary.
When I think of “inflation,” I guess what I mean is “the point at which there will actually be more new dollars chasing the same number of goods.” This won’t happen until the original depositor depletes his account balance and upsets the bank’s reserve ratio.
It’s not easy to define, and you made a good point.
Acknowledged. The details weren’t pertinent to your point. Still, I think it’s good to be as accurate as possible. Statists will pick out errors and point to them, claiming that “Austrians are deluded,” stuff like that. People unfamiliar with FRB might read something like this, then come away with the wrong idea.
Then it’s clearly inflationary. $100 with 10% reserves increases the money supply by $90 for a total of $190. When the loan is repaid, the money supply will contract back to $100.
The wiki explanation you provided contradicts what you say. Your own definition of inflation amounts to an increase in the money supply and according to even the wiki article, that’s what is taking place. An increase in the money supply.
No no. The Fed does not need to create a single penny. The bank notes or newly created deposits are used in exchange as money substitutes. We call these fiduciary media and they are part of the money supply. The Fed orchestrates this inflationary credit expansion but it does not need to create money until it wishes to inject more liquidity into the system so that the banks can further pyramid on top of that.
The supply increases, but not necessarily the number of new dollars actually chasing the same number of goods (see the edit to my earlier post). The dollars in the depositor’s account remain “inert” with respect to the buying power of dollars in general, until the depositor actually uses them to buy something.
This I don’t understand.
Let’s suppose Mr. MOTS deposits $100 in Effar Bank, then Effar Bank lends $90 to Gates. Effar Bank has $90 in loans, $10 in deposits, but MOTS’s balance still shows the full $100.
Then, MOTS writes a check for $100, and his bank balance now shows $0.00.
Effar Bank must replenish $10, somehow, to meet the minimum 10% reserve requirement. At this point, the Fed lends Effar Bank the $10.
So it is inflationary according to your definition
So now you’re talking about not being a rise in prices.
Under a free banking system, unless the recipient of MOTS’s check is a client at the same bank as Mr. MOTS, the recipient of the check will deposit the check in his own bank. When his bank attempts to redeem the check, the bank of Mr. MOTS is found to be insolvent.
Under central banking, the central bank will coordinate this process by essentially acting as a clearance house. It will make sure that all banks expand at the same rate so that the above doesn’t occur. If Mr MOTS’ bank also receives a deposit by one of its clients with a check belonging to the same bank that had received the check from Mr. MOTS’ recipient, then the two can cancel out their debts to one another by simple book keeping
.
The fed lending banks money is just one of the tools available to facilitate the above coordination process. The major point that you have missed is the multiplier factor that results from the process of credit expansion. At the end of the expansion, the bank will have pyramided approximately $900 on top of the original deposit of $100. So the money supply has increased from $100 to $1000. That’s where most of your inflation comes from.
Yes, it is. I retract my earlier assertion that it isn’t, and thank you for clearing that up.
Sort of. I’m making a distinction between new money that sits in an account, unspent (“inert” new money), and new money that is actually spent (“active” new money), because only in the latter case does this inflation cause a rise in prices.
I understand and agree.
I understand and agree.
I understand and agree.
No no, I understand this, and I have not missed it.
I’m not suggesting that the $10 Fed loan is the only, or even the major, “tool.”
What I’m suggesting is that, contrary to what you said, the Fed does need to create new money. It needs to create 10 new dollars to lend to Effar Bank, so that Effar Bank can maintain its 10% reserve ratio.
Although, I would argue this point. I would argue that “most of your inflation” comes from the Fed’s financing of government deficit spending, via the purchase of T-bills.
This continuous injection of new money constitutes the original, and major, inflation.
Given a fixed reserve ratio and Fractional Reserve Banking, inflation via the multiplier effect would level off and cease, without the Federal Reserve.[color=red]*[/color] It is only the Fed’s continous creation of new money that allows inflation to continue.
[color=red]*[/color]In fact, without the Federal Reserve, I suspect Fractional Reserve Banking might also cease to exist.
Edit:
In a sense then, MOTS, by writing a $100 check on an account that actually contains $10, is acting like a miniature Fed. He is spending money that doesn’t exist. This leads me to redefine “inflation” thusly:
Well, the banks use short-term money market instruments for liquidity requirements (federal funds). The FED continuously inject reserves (high-powered money) into the system in order to monetize government debt. This, in turn, allows banks to continuously lend, and reduce their reserves below the regulatory limit of 10% (lowering the interest rate(s)). If banks did this (lower their reserves below the adequate level) in a free-banking environment (without a central bank), interest rates on interbank loans would rise to very high levels. Of course, in a free banking environment, banks would actually compete, and would therefore have a better grip on the demand for money and could set their own reserve ratios, capital ratios, ect.
The point you’re missing, I believe, is the fact that banks pyramid credit on top of the monetary base (reserves) by creating deposits. The amount to which they can do this is determined by the reserve ratio (lower RR extends this process; high velocity).
Thanks. Believe it or not, I read the first edition in October, 1988, and the second edition last August. Although I don’t understand everything in this book, I do understand inflation via the “money multiplier.” I think the wiki article on Fractional Reserve Banking gives a straightforward explanation, as well.
If this is a description of “the money multiplier” as illustrated in the wikipedia article, then I understand this point and am not missing it.
Yes…
I don’t see how this follows.
More dollars lent x lower interest rate = same profit (more or less) as before? This, I understand.