The Mechanics of Money: ECO 285 – Macroeconomics – Dr. D. Foster

The Banking System Reserves (Cash in vault) T-Bills (Liquidity & income) Loans (Banks’ earnings) Demand Deposits (Checking; Transaction) Equity AssetsLiabilities & Equity Accounting Identity: A  L + E M1 +$10,000 +$10,000 +$8,000 +$8,000 +$2,000

Terms Grinding it out: Terms = RR + ER TR = Total Reserves = RR + ER RR = Required Reserves  rr D = required reserve ratio = ER* + ER u ER = Excess Reserves = ER* + ER u  ER* = Desired excess reserves  ER u = Undesired excess reserves  e = the desired excess reserve ratio The Federal Reserve determines rr D. Banks determine e.

Terms Grinding it out: Terms D = (Demand) Deposits C = Currency in circulation  c = desired currency ratio = C + TR MB = Monetary Base = C + TR = C + D M1 = Money Supply = C + D Δ = “Change In …” The public determines c.

Deriving RR, ER* and C RR = Required Reserves = rr D D rr D where rr D is the required reserve ratio (0 to 1), and it is fixed to the level of demand deposits (D). ER* = Desired Excess Reserves = e D epresumed where “e” is the excess reserve ratio and is presumed to be fixed to the level of deposits (D). Note that ER u = TR – RR – ER* and may be +, 0, -. C = Desired Currency Holdings = c D cpresumed where “c” is the currency ratio and is presumed to be fixed to the level of deposits (D).

From Reserves to Money

 With a bank holding positive ER u, they will lend these funds out, raising M1. Those funds become part of another bank’s reserves – they will keep some and lend out the rest. This will continue until ER u are zero. Money Creation: Getting to Equilibrium  With a bank holding negative ER u, they will reduce their loans, lowering M1. [As loans are paid off, deposits fall.] This contraction of the money supply will continue until ER u are zero.

Reserves RR = ER u = Loans Demand Deposits AssetsLiabilities & Equity M1 +$10,000 +$8,000 rr D =20% -$10,000 +$10,000 +$8,000 +$2,000 +$8,000 +$2,000 Money Creation: Getting to Equilibrium

Reserves RR = ER u = Loans Demand Deposits AssetsLiabilities & Equity M1 +$10,000 +$8,000 rr D =20% -$10,000 +$10,000 +$8,000 +$2,000 +$8,000 +$2,000+$8,000 +$8,000 +$6,400 +$6,400 +$1,600 +$1,600 +$6,400 Money Creation: Getting to Equilibrium

Reserves RR = ER u = Loans Demand Deposits AssetsLiabilities & Equity M1 +$10,000 +$8,000 rr D =20% -$10,000 +$10,000 +$8,000 This process will continue until there are no more undesired excess reserves. +$2,000 +$8,000 +$2,000+$8,000 +$8,000 +$6,400 +$6,400 +$1,600 +$1,600 +$6,400 +$5,120 +$6,400 +$6,400 +$5,120 +$1,280 +$5,120 +$1,280 +$19,520 Money Creation: Getting to Equilibrium

 Insure Assets = Liabilities  Identify whether there are +/- ER u   M1 =  Loans = [m*] ER u   D = [1/(1+c)]  M1   C = c  D   TR = -  C  Final values = Beginning values + changes Getting to Equilibrium

Money Creation Problem

, , , MS changed from $80,000 to $300,000 20*11,000 m* = 1/.05 = 20 1*220,000 0*220,000 -(0) C+D +220, ,00015, ,000 15,000

Money Creation Problem ,000 2,400 4, ,893 2,893 0 MS changed from $92,000 to $110, *4,600 m* =1.15/.28 = *18,893.15*16,429 -(2,464) C+D +16,429 2,464 -2, ,893 96,42912,536 83,893 9,643 C changed from $12,000 to $14,464

The Mechanics of Money: ECO 285 – Macroeconomics – Dr. D. Foster

 MB = C + TR = C + RR + ER* in equilibrium  MB = c D + rr D D + e D = (c+rr D +e) D Rearrange and solve for D = [1/ (c+rr D +e)]*MB  M1 = C + D = c D + D = (1+c) D  Substitute in formula for D into M1 to get: M1 = [(1+c)/(c+rr D +e)] MB Appendix – Deriving m*