The Mechanics of 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 AssetsLiabilities & Equity Accounting Identity: A  L + E M1

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 TR = Total Reserves RR = Required Reserves  rr D = required reserve ratio ER = Excess Reserves  ER* = Desired excess reserves  ER u = Undesired excess reserves  e = the desired excess reserve ratio The Fed determines rr D. Banks determine e.

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

rr D ec A Note on the ratios rr D, e 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). 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 

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  M1 = [m*]  MB When there is a  MB the system is in disequilibrium and this dollar amount can be thought of as ER u  M1 = [m*] ER u  M1 = [m*] ER u  D = [1/(1+c)]  M1  D = [1/(1+c)]  M1  C = c  D  C = c  D  TR = -  C  TR = -  C  Loans =  M1 =  D +  C  Loans =  M1 =  D +  C From Reserves to Money

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

The Mechanics of Money: ECO 285 – Macroeconomics – 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*