# Money: how it's made, how it's changed The Mechanics of Money: ECO 473 - Money & Banking - Dr. D. Foster The Banking System Asset s +\$2,000 + \$10,000 Reserves (Cash in vault) T-Bills (Liquidity & income) Loans Liabilities &

Equity Demand Deposits (Checking; Transaction) + \$10,000 +\$8,000 (Banks earnings) Equity Accounting Identity: A L M +\$8,000 Grinding it out: Terms

TR = Total Reserves = RR + ER RR = Required Reserves rrD = required reserve ratio The Federal Reserve determines rrD. ER = Excess Reserves = ER* + ERu ER* = Desired excess reserves ERu = Undesired excess reserves Banks

determine Grinding it out: Terms D = (Demand) Deposits C = Currency in circulation c = desired currency ratio The public determines c. MB = Monetary Base = C + TR M1 = Money Supply = C + D

= Change In Change In Deriving RR, ER* and C RR = Required Reserves = rrDD Can the ratio (rr) be greater than one? Can required reserves be negative? 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? 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 Referring to M1 and MB, with some substitution and rearrangement, we can derive this equilibrium condition: where m* is the Change In money multiplier. When the banking system is not in equilibrium, we can write this out as: Money Creation: Getting to Equilibrium Asset s rrD=20 % e=0 Liabilities & Equity + Reserves +\$2,000 \$10,000

RR = +\$2,000 ERu = +\$8,000 Loans Demand Deposits + \$10,000 +\$8,000 +\$8,000 M 1 \$10,000 Money Creation: Getting to Equilibrium Asset s rrD=20 %

e=0 Liabilities & Equity +\$8,000 + +\$2,000 Reserves +\$1,600 \$10,000 +\$2,000 RR = +\$1,600 +\$8,000 ERu = +\$6,400 Loans Demand + Deposits +\$8,000 \$10,000 +\$8,000 +\$6,400 +\$8,000

M 1 \$10,000 +\$6,400 Money Creation: Getting to Equilibrium Asset s rrD=20 % e=0 Liabilities & Equity +\$8,000 +\$1,600 +\$6,400 + +\$2,000 Reserves +\$1,280 \$10,000 +\$2,000

+\$1,600 RR = +\$1,280 +\$8,000 +\$6,400 ERu = +\$5,120 Loans Demand + +\$6,400 Deposits +\$8,000 \$10,000 +\$5,120 +\$8,000 +\$6,400 This process will continue until there are no more undesired excess reserves. +\$8,000

M 1 \$10,000 +\$6,400 +\$5,120 + \$19,520 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 Money Creation Formulas RR = rrD*D Money = M1 = C + D ER* = e*D

Monetary Base = MB = TR +C ERu = TR-RRER* C = c*D m* = M1 = [m*] ERu D = [1/(1+c)] M1 C = c D TR = -C Loans = M1 = D + C The Mechanics of Money: ECO 473 - Money & Banking - Dr. D. Foster