The Mechanics of Money ECO 473 Money Banking

The Mechanics of Money: ECO 473 - Money & Banking - Dr. D. Foster

The Banking System Assets Liabilities & Equity Reserves +$10, 000 +$2, 000 (Cash in vault) Demand Deposits (Checking; Transaction) T-Bills +$10, 000 (Liquidity & income) Loans +$8, 000 Equity (Banks’ earnings) Accounting Identity: A L + E M 1 +$8, 000

Grinding it out: Terms n TR = Total Reserves = RR + ER n RR = Required Reserves rr. D = required reserve ratio § n The Federal Reserve determines rr. D. ER = Excess Reserves = ER* + ERu § ER* = Desired excess reserves § ERu = Undesired excess reserves § e = the desired excess reserve ratio Banks determine e.

Grinding it out: Terms n D = (Demand) Deposits n C = Currency in circulation § c = desired currency ratio The public determines c. n MB = Monetary Base = C + TR n M 1 = Money Supply = C + D n Δ = “Change In …”

Deriving RR, ER* and C n RR = Required Reserves = rr. D • D Can the ratio (rr) be greater than one? Can required reserves be negative? n ER* = Desired Excess Reserves = e • D Why would a bank desire to hold excess reserves? How is it that undesired excess reserves can be negative? n C = Desired Currency Holdings = c • D 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?

From Reserves to Money w

Money Creation: Getting to Equilibrium Assets Liabilities & Equity Reserves rr. D=20% e = 0 RR = ERu = Loans +$10, 000 +$2, 000 Demand Deposits +$2, 000 +$10, 000 +$8, 000 M 1 -$10, 000

Money Creation: Getting to Equilibrium Assets Liabilities & Equity Reserves rr. D=20% e = 0 RR = ERu = Loans +$10, 000 +$1, 600 +$2, 000 +$8, 000 Demand Deposits +$1, 600 +$2, 000 +$10, 000 +$8, 000 +$6, 400 +$8, 000 M 1 -$10, 000 +$6, 400

Money Creation: Getting to Equilibrium Assets Liabilities & Equity Reserves rr. D=20% e = 0 RR = ERu = Loans +$10, 000 +$6, 400 +$1, 600 +$2, 000 +$8, 000 +$1, 280 Demand Deposits +$1, 280 +$1, 600 +$2, 000 +$10, 000 +$8, 000 +$6, 400 +$5, 120 +$6, 400 +$8, 000 +$5, 120 +$8, 000 +$6, 400 This process will continue until there are no more undesired excess reserves. +$8, 000 M 1 +$6, 400 +$5, 120 -$10, 000 +$19, 520

Arriving at Equilibrium w Insure Assets = Liabilities w Identify whethere are +/- ERu w M 1 = Loans = [m*] • ERu w D = [1/(1+c)] • M 1 w C = c • D w TR = - C w Final values = Beginning values + changes

Money Creation Formulas w RR = rr. D*D w ER* = e*D w ERu = TR-RR-ER* w C = c*D w

The Mechanics of Money: ECO 473 - Money & Banking - Dr. D. Foster