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The Mechanics of Money:

The Mechanics of Money:. ECO 285 – Macroeconomics – Dr. D. Foster. The Banking System. Assets. Liabilities & Equity. Reserves (Cash in vault…) T-Bills (Liquidity & i) Loans (Banks’ B&B). Demand Deposits (Checking; Transaction) Equity. M1. Accounting Identity: A  L + E.

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The Mechanics of Money:

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  1. The Mechanics of Money: ECO 285 – Macroeconomics – Dr. D. Foster

  2. The Banking System Assets Liabilities & Equity Reserves(Cash in vault…) T-Bills(Liquidity & i) Loans(Banks’ B&B) Demand Deposits (Checking; Transaction) Equity M1 Accounting Identity: A  L + E

  3. The Role of the “Fed” • The Fed buys/sells Treasury securities. • This raises/lowers bank reserves. • This raises/lowers excess reserves. • This causes banks to increase/decrease loans. • This will raise/lower measured money, M1.

  4. The Banking System Reserves T-Bills Loans Deposits (Transactions) M1

  5. Grinding it out: Terms • 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 determines rrD. Banks determine e.

  6. 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.

  7. A Note on the ratios rrD, e 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 presumedto be fixed to the level of deposits (D). • C = Desired Currency Holdings = c •D • where “c” is the currency ratio and is presumedto be fixed to the level of deposits (D).

  8. From Reserves to Money

  9. From Reserves to Money

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

  11. Money Creation Problem

  12. Money Creation Problem .05 m* = 1/.05 = 20 0 0 4,000 0 11,000 MS changed from $80,000 to $300,000 20*11,000 +220,000 1*220,000 +220,000 0 0*220,000 0 -(0) C+D +220,000 15,000 300,000 15,000 0 0 +285,000

  13. Money Creation Problem .10 .03 .15 m* =1.15/.28 = 4.1071428 8,000 2,400 4,600 MS changed from $92,000 to $110,893 4.107*4,600 +18,893 .8695*18,893 +16,429 2,464 .15*16,429 -2,464 -(2,464) C+D +18,893 C changed from $12,000 to $14,464 12,536 96,429 9,643 2,893 0 83,893

  14. The Mechanics of Money: ECO 285 – Macroeconomics – Dr. D. Foster

  15. 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

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