Introduction
When bank loans are repaid, the money supply typically decreases. This article explains the process, the impact on bank reserves, and the role of the multiplier effect.

The Behavior of Money Supply When Bank Loans Are Repaid

When a bank grants a loan, it creates money by crediting the borrower's account, which increases the money supply. This happens because the borrower can now spend the loaned amount, adding to the total money in circulation. Conversely, when the borrower repays the loan, the bank reduces the borrower's account balance, effectively removing that money from circulation. This reduction in deposits leads to a decrease in the money supply.

Why the Money Supply Contracts

The process of loan repayment impacts the money supply in a way that can be summarized as follows:

Loan Creation

When a bank grants a loan, it creates an equivalent amount of money in the borrower's account. This increase in the money supply is temporary, as the newly created money remains in circulation until it is spent.

Repayment of Loans

When the borrower repays the loan, the bank reduces the borrower's account balance. This reduction in deposits directly decreases the money supply, as the previously created money is no longer in circulation. This process can be seen as a form of money destruction, where the money that was created during the loan issuance is now being destroyed upon repayment.

Impact on Bank Reserves

As loans are repaid, the bank's reserves increase since the loan amount is returned to the bank. However, the overall money supply decreases because the money that was previously created during the loan issuance is now being removed from circulation. This is a crucial point to understand, as it highlights the relationship between loan repayments and the money supply.

Multiplier Effect and Reserve Requirements

The money supply can be influenced by the reserve requirement ratio. If banks are required to hold a certain fraction of deposits as reserves, the repayment of loans can affect their ability to create new loans. This, in turn, further influences the money supply. The multiplier effect means that a relatively small change in reserves can lead to a larger change in the money supply.

Key Misconceptions

Myth 1: Base Money (MB) Decreases
There is a misconception that when loans are repaid, the base money (MB) decreases. This is not the case. The Federal Reserve (Fed) is responsible for creating base money (MB), which can only change through transactions between the government and the private sector. The reserves (a component of MB) do not increase or decrease when a bank creates a loan or when a deposit is made. Instead, pre-existing reserves simply move between reserve accounts at the Fed as banks conduct transactions.

Myth 2: Interest on Repaid Loans Creates New Money
Another misconception is that the interest on repaid loans creates new money. However, this is not accurate. When a loan of $1000 with an interest repayment of $1050 is fully repaid, the $1000 of M1 money is extinguished, and the $50 of interest is simply transferred from the borrower's account to the bank's account as bank profit. This process does not create new money but rather moves existing money from one party to another.

Myth 3: Assets and Liabilities Are Not Equal
It is also important to understand that the amount we owe on a loan (liability) is equal to the amount the bank has created in the form of dollars in our accounts (assets). For example, a loan of $1000 with an obligation to repay $1050 does not increase the bank's assets; it only represents a transfer of money from the borrower to the bank. When the loan is fully repaid, the assets and liabilities return to their original state, showing that the principles of accounting (assets liabilities) hold true.

Conclusion

In conclusion, when bank loans are repaid, the immediate effect is a contraction of the money supply as the money that was created during the loan issuance is effectively destroyed. This process is influenced by the reserve requirement ratio and the multiplier effect. Understanding these concepts is crucial for grasping the dynamics of monetary policy and financial market behavior.