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The Mechanics of Money:

The Mechanics of Money:. ECO 473 - Money & Banking - 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 473 - Money & Banking - 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

  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

  7. From Reserves to Deposits • TR = total reserves = RR + ER • RR = Required Reserves = rrD•D • where rrD is the required reserve ratio (0 to 1), • D is the level of (demand) deposits. • ER = ER* + ERu (desired + undesired) • where ER* = Desired Excess Reserves = e •D • where “e” is the excess reserve ratio (0 to 1).

  8. From Reserves to Deposits • If e=0, then …D = (1/rrD) • RR = (1/rrD) • TR and . . . ΔD = (1/rrD)·ΔTR… and, with any value for ER, we can writeΔD = (1/rrD)·ΔERU

  9. From Reserves to Deposits • Where it is assumed: • No currency is heldby the public. • i.e., all money is held as bank deposits, • Banks hold no excess reserves. Then, (1/rrD) is the maximumvalue of the money multiplier (m*)

  10. From Reserves to Money • MB = C + TR • C = currency = c •D • where c is the currency ratio. • MB = c •D + rrD•D + e •D = (c+rrD+e) •D • M1 = C + D = c •D + D = (1+c) •D • Solve to get M1 = [(c+1)/(c+rrD+e)] • MB where […] is the “real” money multiplier, m*

  11. From Reserves to Money • 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.

  12. From Reserves to Money • M1 = [(1+c)/(c+rrD+e)] • MB • Where the system is in disequilibrium… • MB can be replaced withERu • M1 = […] • ERu • D = [1/(1+c)] • M1 • C = c • D • TR = -C • Loans = M1 = D + C

  13. Money Creation Problem

  14. Quick Hits • Money multipliers are derived from the data: • M1/MB = m*1 and M2/MB = m*2 • Fed targets for money depends on: • which multiplier is more stable, and • which M is a better predictor of GDP.

  15. Quick Hits

  16. Money Data

  17. Money Data

  18. Money Data

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

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