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The Mechanics of Money:

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Presentation on theme: "The Mechanics of Money:"— Presentation transcript:

1 The Mechanics of Money:
ECO Money & Banking - 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 [=TR-RR-ER*] 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* 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 Who Determines changes in the Money Supply?
We can also write this as: M1 = [(1+c)/(c+rrD+e)] • MB The Fed can change TR. The Fed could change C. The Fed can change rrD. Banks determine e. The public determines c.

8 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.

9 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.

10 Money Creation: Getting to Equilibrium
Assets Liabilities & Equity Reserves RR = ER* = ERu = Loans Demand Deposits rrD=20% e = 0 M1

11 Money Creation: Getting to Equilibrium
Assets Liabilities & Equity Reserves RR = ERu = Loans Demand Deposits rrD=20% e = 0 M1

12 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

13 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

14 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

15 Arriving at 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

16 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+ 𝑟𝑟 𝐷 +𝑒 M1 = [m*] • ERu D = [1/(1+c)] • M1 C = c • D TR = -C Loans = M1 = D + C

17 Money Creation Problem

18 Money Creation Problem
.10 m* = 1/.10 = 10 8,000 What happened to C? What happened to MB? 7,000 +70,000 10*7,000 +70,000 1*70,000 0*70,000 -(0) +70,000 C+D MS changed from $80,000 to $150,000 15,000 150,000 15,000 +135,000

19 The Mechanics of Money:
ECO Money & Banking - Dr. D. Foster

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


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