Now that we know that we can view interest rates
as essentially the price of renting money.
I want to go through a bunch of scenarios
just so we can understand how different things that
happen in the economy might effect interest rates.
I just draw a bunch of supply and demand curves
right over here. Once again we're talking about
the market for essentially renting money.
That right over here is the price of money,
which we know is the interest rate on the
vertical axis. Then the horizontal axis we have
the quantity of money that is borrow or lent
in a given time period. Quantity and this is a
given time period that is borrowed or lent.
Quantity borrowed in a year. We know there is
some ... if we just wanted to draw a demand curve
our starting demand curve. The first few dollars
out in the economy people are willing to pay
a very high interest rate on them. Then every
incremental dollar after that people get less
marginal benefit. They might not find as good
of a place to put that money. Their borrowing
it for a reason. Their either going to borrow
to consume to buy something that they always
wanted that they think will make them happy,
or more likely their borrowing it to invest it
and hopefully getting a return higher than what
they are borrowing at. You have a marginal
benefit curve that would be downward sloping
something like that. Maybe it looks something
like that. That is our demand curve or our marginal
benefit curve.
The supply curve. Now, once again this is the
exact same logic we use with the demand and supply
curve for any good or service.
For money might look like this. Those first
few dollars someone has a very low opportunity
cost of lending it out, so, their willing to
lend it out at a very low interest rate.
Then every incremental dollar after that theirs
higher opportunity cost, and people will lend
it out at a higher and higher rate.
Then you have a market equilibrium interest rate.
Let me copy and paste this. Then we could think
about what happens in different scenarios.
Copy and paste. Now we have 2 scenarios that
we can work on, and then let me just do 1 more. 3 scenarios.
Let's think of a couple. Let's say that the central
bank of our country, in the United States,
that would be the Federal Reserve, the central
bank prints more money. Then decides to lend
out that money. That actually is ... in the
previous video I talked about the central bank
printing money and then dropping it from
helicopters, that is not how money is actually
distributed. It is disturbed when central banks
print money. The way that it enters into circulation
in most countries is that the central bank
then goes and essentially lends that money.
The way it's done in the US Fed, most part
they go out and buy government securities
which is essentially lending money to the
Federal Government. They do that because that's
considered to be the safest investment.
They go out there and they lend money.
If this is our original supply curve.
If this is our original supply curve, but now
your Federal ... Central Bank is printing more money
and lending it out. What is going to happen
over here? Your supply curve is going to shift
to the right at any given price, at any given
interest rate. Your going to have a larger
quantity of money being available. It might look
something like ... your new supply curve might
look something like that.
Assuming that's the only change that happens
you see its effect. Your new equilibrium price
of money, the rent on money, or the interest
rate on money is now lower. That's why when the
Federal Reserves say I want to lower interest
rates, they do so by printing money.
They print that money, and they lend it out in
the market. That essentially has the effect of
lowering interest rates.
Let's think about another situation.
Let's say this is the Fed prints and lends money.
Their lending the money by buying government bonds.
When you buy a government bond, your essentially
lending that money to the Federal Government .
I've done other videos on that where we go into
a little bit more detail on that.
Let's think of another situation.
Let's think about consumer savings go down.
One interesting thing about savings, savings
and investment are two opposite sides of the same
coin. When you save money ... you literally put
it into a bank. You have the whole financial
system right over here. This is the finincial
system. Financial system. That money goes out and
is lent to other people. For the most part,
hopefully, that money when it's lent is used
to invest in someway. This is lending.
If consumer savings goes down that means the
supply of money will be shifted to the left.
At any given price and any given interest rate
their be less money available.
In this situation our supply curve is shifting
to the left. That would increase interest rates.
Then you could even make an argument that if
consumers savings is going down consumers are
going to borrow less as well. You could
argue that maybe demand would go up as well.
Your demand could go up and that would make
the equilibrium interest rate even even higher.
Let's do another scenario. Let's say that the
Federal Government in an effort to ... let's
say that for whatever reason, their trying to
finance a war or some type of public works project
and they don't want to raise taxes.
The government decides to borrow a lot more money.
The government is essentially going expand it's deficit.
The government is going to borrow money.
Here our supply isn't changing. I'm assuming
the Central Bank isn't changing it's policies,
how much it's printing. Savings rates aren't
changing. The demand is going to go up.
Government is borrowing money. The government
is going to borrow more money than it was already
doing. At any given price the demand for money
is going to increase. We're going to shift
to the right, and our new equilibrium interest
rate, remember the rental price of money, is
going to go up.
The whole point of this is just to show you
that you really can't think about money like any other
good or service. If the supply of money goes
up then the price of money, which is interest
rates, will go down. Let me write this down.
If the supply goes up then the price, which is
just the interest rates goes down.
If the demand goes up, then the price of money
will go up. Interest rates will go up.
Then we think about all the other combinations
where demand goes down, then interest would
go down. Which is essentially just price.
If supply went down, interest rates would go up.
If something becomes more scarce the price of
it goes up. The whole point of this is just
to show that it's not that complicated.
You'll see people say, oh, government borrowing,
it's crowding out other savings, interest rates
go up, and it sounds like something deep is
happening. They are just talking about the
supply and demand for money. You just have to
remember that interest rates really are nothing
more than the rental price for money.