The Mechanics of Money: ECO Money & Banking - 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

The Role of the Fed buyssells  The Fed buys/sells Treasury securities. raiseslowers  This raises/lowers bank reserves. raiseslowers  This raises/lowers excess reserves. increasedecrease  This causes banks to increase/decrease loans. raiselower  This will raise/lower measured money, M1.

The Banking System Reserves T-Bills Loans Deposits (Transactions) M1

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.

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. Terms Grinding it out: Terms

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

 We can also write this as:  M1 = [(1+c)/(c+rr D +e)]  MB The Fed can change TR. The Fed could change C. The Fed can change rr D. Banks determine e. The public determines c. Who Determines the Money Supply?

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 Arriving at Equilibrium

Money Creation Formulas  RR = rr D *D  ER* = e*D  ER u = TR-RR-ER*  C = c*D

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

Quick Hits  Money multipliers are derived from the data: M1/MB = m* 1 and M2/MB = m* 2  Fed targets for money depends on: which multiplier is more stable, and which M is a better predictor of GDP.

Quick Hits

Money Data

The Mechanics of Money: ECO Money & Banking - 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*