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(1) Toyland earns $$100,000 revenue in cash this week. Toyland managers use this $100,000 to pay down a short-term loan from Bank One. Bank One keeps the cash in reserve. As a result of this transaction M1 [x] and M2 [y]

(2) Bank of America takes $25,000 from reserves and makes a loan to Sissy. Sissy uses the funds to purchase a Mini Cooper. The funds are then deposited in the car dealer's checking account. As a result of this transaction M1 [x] and M2 [y]

The answers for these 2 are:

(1) [x] = decreases, [y] = decreases

(2) [x] = increases, [y] = increases

I had gotten both of these questions incorrect because I considered Bank Reserves to be that part of the money that the money keeps in vaults, etc. in a fractional reserve system. Usually the bank reserves would be considered about 10% of the total bank's worth. Am I correct? Or wrong? If so, why?

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  • $\begingroup$ what kind of "vaults"? Also there seems to be an extra "money" in the sentence. $\endgroup$ – Giskard Jul 20 '15 at 11:52
  • $\begingroup$ Vaults like a large room or chamber used for storage. Or simply where the physical paper currency (or physical coins like dimes) money that the bank simply holds is kept. While the other 90% of the money would be loaned out to individuals, etc. $\endgroup$ – Adam Staples Jul 20 '15 at 11:54
  • $\begingroup$ I meant whether it is their vault or the central bank's. $\endgroup$ – Giskard Jul 20 '15 at 11:57
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    $\begingroup$ en.wikipedia.org/wiki/Bank_reserves $\endgroup$ – Giskard Jul 20 '15 at 13:43
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    $\begingroup$ So therefore Bank_reserves are not counted in M1 or M2? I guess if that's the case then both answers make sense. $\endgroup$ – Adam Staples Jul 20 '15 at 14:23
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Using the Federal Reserve's definition for M1 (warning, M definitions can vary between countries, so always check the local definition):

"M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions)."

Note, reserves are not counted as part of M1. The explanation for that is in the answer here:

How does a cash deposit change the M1 Measure of the Money Supply

So in question 1) we are told that Toyland earns cash and uses it to pay down a short term loan from Bank One. Critically we are not told where Toyland has its account. Note, we can't assume that Toyland doesn't have a bank account, since the bank would have insisted on it having one to receive the loan. We'll assume to make things simple it was Bank One.

If it receives cash from the public that was not in the banking system, then Bank One's cash reserves would increase. At the same time so would Toyland's deposit account, so there is no change to M1 at that point in time. The decrease in the 'cash held by the public' outside the system is matched by the increase in the deposit account at Bank One.

Now Toyland pays off its loan. There is no change to the cash reserves, Bank One simply decreases its loan book, and removes the money from Toyland's deposit account. So M1 decreases, because the loan is repaid and the liability deposit money is removed from the banking system. M2 is essentially M1 + some savings deposits and money market funds, so M2 will decrease as well.

2) Bank of America takes $25k from its cash reserves and makes a loan.

Actually, Bank of America doesn't do that. Bank of America makes a loan by creating a liability deposit account/entry for that amount, and a matching entry in its loan book. Creating that deposit money increases M1 (and M2). Whatever Sissy does with the money subsequently is irrelevant.

Bank Nerd Trivia... 10% is the figure used for reserves in the example Keynes wrote for the 1931 Macmillan report, which has been subsequently copy and pasted into the textbooks. I've never seen an actual banking system that uses 10% - in 1930's reserve ratios were usually 20%+, whereas these days they are down to 1-2% in Europe. Although the US has a 10% reserve rate on "Net Transaction Accounts", it has a 0% rate on all other accounts, which makes the actual rate open to account classification decisions by the US banks.

Keynes has a lot to answer for btw., the textbook description is horribly confusing, and also partially incorrect. (Try applying loan repayments to the examples it uses.)

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