[Borodog]

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Lowering interest rates by increasing reserves

Are you saying that when the Fed lowers interest rates it first creates paperless funds (in other words expands the money supply) for commercial banks so that they can make more loans to people. So making more loans to people is the big goal right? Is this the first step in lowering the interest rate or did I misunderstand you? Sorry I'm sounding so ignorant, I just did not realize that the term "lowering the interest rate" meant creating more funds for banks to loan out.

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The real intention of the Fed when it lowers the interest rate is to "stimulate the economy." In other words, it wants more transactions taking place in the economy. It does this by lowering interest rates, which encourage businesses and individuals to take out loans with the intention of buying stuff with the money.

The reason that lowering the interest rate encourages people to take out a loan is that the interest rate is essentially the price of money over a certain time horizon. If I asked you to loan me $10,000 for a year, and promised to give you exactly $10,000 after one year, you would laugh at me (unless there were special circumstances like we were good friends, etc.). I would have to pay you a price, say promise to give you $11,000 after one year for your $10,000 now. That would be a 10% interest rate.

So the market interest rate is the rate set by the supply of loanable funds (i.e. money saved up and not spent by people on consumption) and the demand for loans. The higher the supply of loanable funds, the lower the price of money (the interest rate). The lower the supply, the higher the interest rate. So by creating more money to be loaned out, the Fed increases the supply of loanable funds, which lowers the interest rate, which encourages people to take out loans, because it coasts them less to do so, which encourages spending in the economy. The problem is that this whole process, while it appears great (a boom) it is actually very damaging to the structure of the economy.

Make sense?

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And why would banks want to make all these loans if people are in such a shaky position with high mortgages and credit card problems? I would guess they don't want to loan to private citizens as much as they do to businesses and corporations. Gah, economics and I are complete strangers [img]/images/graemlins/grin.gif[/img]

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The banks want to make loans because they make interest off of them. Now they will obviously be willing to make shakier loans if they are making interest off of money that was created from nothing than if the principle they are risking was not created from nothing. They still want to make loans to the best risks possible, but hey, when the good risks are all serviced and you still want to make loans and earn interest, you will start making shakier and shakier loans.

Also, it wasn't just banks that were making sub-prime mortgages. There were a lot of mortgage brokers looking to cash in on the mortgage bonanza created by the housing boom. A lot of funding for these mortgages came from real savings, i.e. investors, rather than being printed from nothing. But since they must compete with the banks for loans, when the banks depress the interest rates, they do so market wide. Those investors turned around and sold those mortgages to be packaged as mortgage backed securities. The brokers and their investors were making money hand over fist; it was the people who bought the MBSs that were eventually left holding the bag.

And remember, at the time that all of these shaky mortgages were being put together, all the participants thought that the market warranted it because of skyrocketting real estate values. It was only after the housing bubble popped that the problem was revealed, which is the nature of a recession across the entire economy.