Bryan Caplan  

What Responds to Interest Rates?

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Bryan's Right... I Hate Monetary Theory...

In our continuing dialogue, Arnold observes that:


The Fed supplies bank reserves. Mechanically, it goes into the "repo" market, which is the market for loans collateralized by Treasury securities. When the Fed wants to expand the money supply, it goes long in the repo market (meaning that it makes more loans), which lowers the interest rate in the repo market. So as a practical matter, the interest rate goes down whether Bryan adjusts his money demand or not.

The repo market, unlike Bryan, gets very exercised over tiny changes in interest rates.

Unless I misunderstand Arnold, this conflates interest-elasticity of money demand with interest-elasticity of loan demand. People adjust their borrowing to interest rates all the time. But cash balances? That's hard to believe.

So is "Bryan's personal money demand function the ultimate determinant of interest elasticity"? Of course not. I'm open to the possibility that my interest-elasticity of money demand is strangely low.

But I don't think it is. When I've asked economists "Do you hold less money when interest rates rise?," they usually admit that they don't. And we're trained to think we should! If we asked non-economists the same question, I bet that most would simply be baffled.

Institional money demand is probably a little more sensitive than individual money demand, but I still doubt the total effect is large.

Economists have come up with a lot of crazy theories about what responds to interest rates. My favorite is that higher interest rates increase fertility, because parents foresee that they'll be able to afford larger bequests. The view that higher interest rates reduce cash holdings is a lot more plausible, but that's not saying much.


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COMMENTS (2 to date)
Fritz writes:

Throw negative interest rates & hyper inflation into the picture, then you will find your elasticity demand for cash.

Karl Smith writes:
Unless I misunderstand Arnold, this conflates interest-elasticity of money demand with interest-elasticity of loan demand. People adjust their borrowing to interest rates all the time. But cash balances? That's hard to believe

Byran I have a hard time seeing the difference. More loans is more money.

When Bank of America issues you a loan what they really issue you is a checkable account. That is money.

Now most loans are to buy something in particular. However, the person from whom you buy something can keep the extra money as increased money balances, they can save it back at the bank or they can buy something with it themselves.

Suppose they do the first - then money balances have increased.

Suppose they do the second - then the bank will simply reloan that same amount to someone else starting the process over again.

Suppose they do the third - now that person has more money for which they have three options. . .

In the end all of the extra loans have to end up as money somewhere.

The only way it does not is if the banking industry cannot entice the public to hold more outstanding loans by lowering the interest rate. This is a liquidity trap.

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