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

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

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

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

5. Deriving RR, ER* and C RR = Required Reserves = rrD•D
where rrD 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
where “e” is the excess reserve ratio and is presumed to be fixed to the level of deposits (D).
Note that ERu = TR – RR – ER* and may be +, 0, -.
C = Desired Currency Holdings = c •D
where “c” is the currency ratio and is presumed to be fixed to the level of deposits (D).

6. where m* is the “money multiplier.”
From Reserves to Money
We know that: M1 = C + D MB = C + TR = C + RR + ER* + ERu
In “equilibrium” (no more money creation/destruction): ERu = 0
With some substitution and rearrangement, we get: 𝑀1= 1+𝑐 𝑐+ 𝑟𝑟 𝐷 +𝑒 ∙𝑀𝐵= 𝑚 ∗ ∙𝑀𝐵
where m* is the “money multiplier.”

7. From Reserves to Money
When the banking system is not in equilibrium, we can write this out as: ∆𝑀1= 1+𝑐 𝑐+ 𝑟𝑟 𝐷 +𝑒 ∙ 𝐸𝑅 𝑢
When ERu is positive, banks will create more money.
When ERu is negative, banks will destroy money.
When ERu is zero, the banking system is in equilibrium.

8. Money Creation: Getting to Equilibrium
With a bank holding positive ERu, 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 ERu are zero.
With a bank holding negative ERu, they will reduce their loans, lowering M1. [As loans are paid off, deposits fall.] This contraction of the money supply will continue until ERu are zero.

9. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ERu =
Loans
Demand Deposits
+$10,000
+$2,000
rrD=20%
+$2,000
+$10,000
+$8,000
+$8,000
+$8,000 M1
-$10,000

10. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ERu =
Loans
Demand Deposits
+$2,000
+$10,000
+$8,000
+$1,600
rrD=20%
+$1,600
+$2,000
+$8,000
+$10,000
+$8,000
+$6,400
+$8,000
+$6,400
+$8,000 M1
+$6,400
-$10,000

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

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

13. Money Creation Problem

14. Money Creation Problem
.05
m* = 1/.05 = 20
4,000
11,000
MS changed from $80,000 to $300,000
+220,000
20*11,000
+220,000
1*220,000
0*220,000
-(0)
+220,000
C+D
15,000
300,000
15,000
+285,000

15. Money Creation Problem
.10
.03
.15
m* =1.15/.28 =
8,000
2,400
4,600
MS changed from $92,000 to $110,893
+18,893
4.107*4,600
+16,429
.8695*18,893
2,464
.15*16,429
-2,464
-(2,464)
+18,893
C+D
C changed from $12,000 to $14,464
12,536
96,429
9,643
2,893
83,893

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

17. Money Creation Formulas
RR = rrD*D
ER* = e*D
ERu = TR-RR-ER*
C = c*D
Money = M1 = C + D
Monetary Base = MB = TR + C
m* = 1+𝑐 𝑐+𝑟𝑟𝐷+𝑒
M1 = [m*] • ERu
D = [1/(1+c)] • M1
C = c • D
TR = -C
Loans = M1 = D + C