1. The Mechanics of Money:
ECO 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
e = the desired excess reserve ratio
ERu = Undesired excess reserves
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. From Reserves to Money
When the banking system is not in equilibrium, to restore equilibrium the money supply will change: ∆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.
money multiplier

7. 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.

8. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ERu =
Loans
Demand Deposits
+$10,000
+$2,000
rrD=20% e = 0
+$2,000
+$10,000
+$8,000
+$8,000
+$8,000 M1
-$10,000

9. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ERu =
Loans
Demand Deposits
+$2,000
+$10,000
+$8,000
+$1,600
rrD=20% e = 0
+$1,600
+$2,000
+$8,000
+$10,000
+$8,000
+$6,400
+$8,000
+$6,400
+$8,000 M1
+$6,400
-$10,000

10. 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% e = 0
+$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

11. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ERu =
Loans
Demand Deposits
+$10,000
rrD=20% e = 0 c = 0
+$2,000
+$10,000
+$8,000
What will be the change in the MS?
Money multiplier = (1)/(.20) = 5
∆MS = 5*(+$8000) = +$40,000
-$10,000

12. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ER* = ERu = Loans
Demand Deposits
$30,000
rrD=20% e = 5% c = 10%
$20,000
$100,000
$5,000
+$5,000
What do we know?
C = $10,000
MS = $110,000
MB = $40,000
$70,000
What will be the change in the MS?
Money multiplier = (1.1)/(.35) = 3.143
∆MS = 3.143*(+$5000) = +$15,714

13. Money Creation: Getting to Equilibrium
Assets
Liabilities & Equity
Reserves RR = ER* = ERu = Loans
Demand Deposits
$20,000
rrD=15% e = 3% c = 12%
$22,500
$150,000
$4,500
-$7,000
What do we know?
C = $18,000
MS = $168,000
MB = $38,000
$130,000
What will be the change in the MS?
Money multiplier = (1.12)/(.3) = 3.733
∆MS = 3.733*(-$7000) = -$26,133

14. 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
Problems – find ∆MS:
1. rrD=5%, e*=5%, c=0
2. rrD=5%, e*=5%, c=5%
3. rrD=10%, e*=5%, c=10%
4. rrD=12%, e*=5%, c=0
5. rrD=7%, e*=4%, c=20%
Answers
1. +$50,000
2. +$35,000
3. -$22,000
4. -$52,941
5. +$11,613

15. The Mechanics of Money:
ECO Macroeconomics - Dr. D. Foster