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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: 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
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.
The Banking System Reserves T-Bills Loans Deposits (Transactions) M1
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.
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.
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).
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
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
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
The Mechanics of Money: ECO 285 – Macroeconomics – Dr. D. Foster
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