The Mechanics of The Mechanics of Money:Money:

ECO 285 – Macroeconomics – Dr. D. Foster

The Banking System

Reserves(Cash in vault…)

T-Bills(Liquidity & i)

Loans(Banks’ B&B)

Demand Deposits (Checking; Transaction)

Equity

Assets

Liabilities & Equity

Accounting Identity: A L + E

M1

The Role of the “Fed”

The Fed buysbuys/sellssells Treasury securities.

This raisesraises/lowerslowers bank reserves.

This raisesraises/lowerslowers excess reserves.

This causes banks to increaseincrease/decreasedecrease loans.

This will raiseraise/lowerlower measured money, M1.

The Banking System

Reserves

T-Bills

Loans

Deposits (Transactions)

M1

Grinding it out: TermsTerms

TR = Total Reserves

RR = Required Reserves rrD = required reserve ratio

ER = Excess Reserves ER* = Desired excess reserves

ERu = Undesired excess reserves

e = the desired excess reserve ratio

The Fed determine

s rrD.

Banks determin

e e.

Grinding it out: TermsTerms

D = (Demand) Deposits

C = Currency in circulation c = desired currency ratio

Δ = “Change In …”

MB = Monetary Base

M1 = Money Supply

The public determine

s c.

A Note on the ratios rrrrDD, ee and cc

RR = Required Reserves = rrD•D

where rrrrDD 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 “ee” is the excess reserve ratio and is presumedpresumed

to be fixed to the level of deposits (D).

C = Desired Currency Holdings = c •D where “cc” is the currency ratio and is presumedpresumed to be

fixed to the level of deposits (D).

From Reserves to Money

From Reserves to Money

M1 = [m*] • M1 = [m*] • MBMB When there is a MB the system is in

disequilibrium and this dollar amount can be thought of as ERu

M1 = [m*] • ERM1 = [m*] • ERuu

D = [1/(1+c)] • D = [1/(1+c)] • M1M1

C = c • C = c • DD

TR = -TR = -CC

Loans = Loans = M1 = M1 = D + D + CC

From Reserves to Money

Money Creation Problem

rr =

e =

c =

$15,000 Deposits $80,000RRDes. ERUndes. ER

$65,000

DepositsRRDes. ERUndes. ER

Money Creation Spreadsheet Form

Loans

Change in L =

Assets LiabilitiesReserves

Change in M1 = Change in D = Change in C =

Change in TR =

Assets LiabilitiesReserves

Loans

Money Creation Problem

rr =

e =

c =

$15,000 Deposits $80,000RRDes. ERUndes. ER

$65,000

DepositsRRDes. ERUndes. ER

Money Creation Spreadsheet Form

Loans

Change in L =

Assets LiabilitiesReserves

Change in M1 = Change in D = Change in C =

Change in TR =

Assets LiabilitiesReserves

Loans

.05

0

0

4,0000

11,000

+220,000

0

0

MS changed

from $80,000

to $300,000

20*11,000

m* = 1/.05 =

20

1*220,0000*220,000

-(0)C+D

+220,00000

+220,000

300,00015,000

+285,000

15,000

Money Creation Problem

rr =

e =

c =

$15,000 Deposits $80,000RRDes. ERUndes. ER

$65,000

DepositsRRDes. ERUndes. ER

Money Creation Spreadsheet Form

Loans

Change in L =

Assets LiabilitiesReserves

Change in M1 = Change in D = Change in C =

Change in TR =

Assets LiabilitiesReserves

Loans

.10

.03

.15

8,0002,400

4,600

+18,893

2,893

0

MS changed

from $92,000

to $110,893

4.107*4,600

m* =1.15/.28 = 4.1071428

.8695*18,893.15*16,429

-(2,464)C+D

+16,4292,464

-2,464+18,893

96,42912,536

83,893

9,643

C changed

from $12,000

to $14,464

The Mechanics of The Mechanics of Money:Money:

ECO 285 – Macroeconomics – Dr. D. Foster

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

Appendix – Deriving m*Appendix – Deriving m*