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