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
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
ER* = Desired Excess Reserves = e •D
C = Desired Currency Holdings = c •D
Can the ratio (rr) be greater than one?
Can required reserves be negative?
Why would a bank desire to hold excess reserves?
How is it that undesired excess reserves can be negative?
Explain what it means if “c” is 0.5 versus if it is 10. What would such a difference tell you about the financial system?

6. where m* is the “money multiplier.”
From Reserves to Money
Referring to M1 and MB, with some substitution and rearrangement, we can derive this equilibrium condition: 𝑀1= 1+𝑐 𝑐+ 𝑟𝑟 𝐷 +𝑒 ∙𝑀𝐵= 𝑚 ∗ ∙𝑀𝐵
where m* is the “money multiplier.”
When the banking system is not in equilibrium, we can write this out as: ∆𝑀1= 1+𝑐 𝑐+ 𝑟𝑟 𝐷 +𝑒 ∙ 𝐸𝑅 𝑢

7. 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

8. 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

9. 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

10. 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

11. 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

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