I'm trying to get a better understanding of how interest rates emerge and how they are manipulated. Saw a comment that I wasn't sure how to respond to, and thought it would be a good learning opportunity.

I subscribe to the Austrian focus on human action to understand the economy and the ABCT, but I'm not entirely sure on how interest rates are set or manipulated. As such I've run into a comment that I wasn't sure how to answer, and I would like your take on it. It seems like a good chance to learn more about Austrian Economics, to find out more about what I understand less. I'm fairly certain he thinks that deflation as falling prices leads to a recession somehow, while insisting on seeing inflation as only price increase rather than expansion of the money supply and a lack of price decrease where it would otherwise occur. It's the parts on how interest rates are changed that I'm not sure on in the discussion. To my current understanding, it is caused by the federal reserve loaning out money to big banks while insuring them as a lender of last resort, creating a floor to interest rates. I really need to read more on it, but is there anything you would recommend for this in particular? This is a brief summary of the relevant parts of the conversation: (Predicated with a discussion of inflation and his proposal of "democratization of banking, such that we all control and have a direct link to a central bank and get organize ourselves as banks freely, with the ability to do what banks do".) Me > The issue with inflation, the reason the money supply is important, is that every additional printed dollar reduces the value of all existing dollars. > It is essentially an invisible tax on everyone, only the devaluing effect is delayed, making the new money more useful for whoever gets it first. > Which is pretty much the big banks the central bank loans to and those they loan to. > It is also used to keep interest rates artificially low, leading to a distortion in investment signals and a crash when they inevitably must rise, but that is a bit off topic. _______________________________________ > I'd rather not have a central bank to loan money out with a simple replacement rate currency printing and no bail outs for banks or other businesses. > This system would encourage banks to be far more careful with their investments, as taxpayers wouldn't be on the hook if they go under. > It would seem like the system you describe would promote many people asking for new money loans to their personal bank. > One does not need a central bank simply to become a banker. Other guy > My study of central banking has lead me to conclude they keep interest rates artificially high and ended up paying the price when that pushed the need for low interest rates below 0%. It's hard to consider a mechanism that allows them to force interest rates down—interest rates trend toward 0% as long as we run a meaningful deficit. This is because banks are desperate to shed reserves (reserves are a liability, not an asset) in deficit spending directly creates newly printed bank reserves. In hopes another bank borrows their reserves, they bid interest rates down. If interest rates drop below the target rate, the central bank begins borrowing at the rate it wants the rate to be, creating a floor. > If prices don't move, it's hard to say that the value of a dollar is diminished by the volume of them. It's a strange claim and one I hear often, that a) inflation is not prices and b) that inflation is a tax. It would require that the economy remains at a fixed size and, that output is not affected by money supply, and that prices aren't sticky. Ludwig would approve, but there's a reason most the rest of the Austrians in and after his time got rebranded "Chicago." > Central banking has proved a powerful technology. The country with the most effective central bank generally wins. But giving monopoly rights to private banks to print loan money seems dubiously suboptimal. The question I frequently ask myself: should we consolidate most banking into the public sphere or should we hyper-privatize it. These two are similar, with the difference being in the first option, we collectively own a central bank and have borrowing and deposit rights, or instead we collectively own a central bank and have the same rights to print loans/fiat money that private banks do, for each other. I think the latter is not a mature idea but might lead to the solution to our chronic demand mismatch without requiring a fiscal authority. Me > Consider that, with advances in technology, it may make sense for some goods to become cheaper as their production process is improved. > In this way, merely not seeing prices rise immediately does not mean there is no inflation. > And in the long term, the dollar has lost a huge amount of its value to gradual inflation. > Banks are willing to work in a risky fractional reserve system largely because of the central bank acting as a lender of last resort to protect them from failures, or bank runs. __________________________________________________ > I would need to see some serious evidence to prove that. *(Central banks are a powerful technology.)* > It seems to promote moral hazard and business cycles with its decisions to loan to other banks, rather than let the interest rate be set naturally and allow bad banks to fail. > What do you mean by a chronic demand mismatch? Then he made these two comments http://ift.tt/1MXriMl Hygro's Avatar > Bank loans are not driven by reserves, they are driven by demand. If the central bank does not oblige a bank's need for more reserves, it loses its power to maintain interest rates, ergo it never constrains bank reserves. On the other end, if there's no profitable loans to be made, it doesn't matter how big reserves are. Bank reserves in the past 7 years prove this. It is why quantitative easing for treasuries has done nothing except subtract miniscule interest income. Their "loaned up" amount is not defined by the central bank, but by the private banks responding to expectation of profit (demand). > Rothbard and his school define inflation as the size of the money supply, or quantity. Quantity-inflation is not a thing, price inflation is. It doesn't actually matter if the money supply itself changes, what matters is purchasing power. Quantity of money doesn't dictate the price, it is merely one piece of the equation. He didn't understand how money actually works, neither did Mises, whose book on money I skimmed but have not read. They understood utility great, and should have stuck to microeconomics. Most good economists generally aren't also good monetary economists. > Central banks stopped targeting the money supply a long time ago, because there wasn't much point. Again, the money supply grows and shrinks dramatically second by second. To know if money is working, just compare inflation against unemployment. Unemployment is how deflation is expressed. Inflation is measured by price. Then linked this as the ["Best layman explanation of money in the macroeconomy."](http://ift.tt/15ag3yR) And then he made a final response to someone asking how the purchasing power of money does not change with its supply. > On the most macro level, the volume of economy is changing. If you make more stuff but don't make more money, you risk recession. If you increase the amount of money in a system, that money is going to chase profit. As profit is exhausted, then prices or uninvested savings rise. In a perfect system, you would not have any inflation until every person is employed to the best of their ability, financed to their value delivered, and every piece of capital being used in the most productive way. > This is a reason I favor greater equality—you have more eyes and ears to spot potential profit, and have greater potential aggregate supply. You can employ more people and more capital with greater specialization. > In an unequal economy, rising prices might for financial assets but not for general goods and services, because there isn't demand (i.e. there's the money half of demand, but not the desire half). Here, last decade was an example of above-potential real demand at the top, with below-potential demand at the bottom. It contributed to the crash. > I wish there was an easy tool for me to make and post graphs of this. > Most money is made by banks responding to market conditions, most the rest is made by deficit spending.

link: http://ift.tt/1MXriMr