People also ask
What happens to the money supply when a bank repays a loan?
Even though the bank receives a $1mn payment when the loan is repaid, accounting-wise the bank’s asset and the borrower’s liability are extinguished. Because the asset is gone, the private sector’s overall money supply shrinks by $1mn.
Does a loan count as an increase in the supply?
However, if the loan is made by a bank, then the bank creates the 5 that is loaned and, other things being constant, this counts as an increase in the overall supply of money. The loan is repaid by the borrower transferring 5 of her money back to the lender bank.
What happens to the supply of money in the system?
As the borrower pays back the money to the bank, the supply of money in the system contracts. This is of course until the bank lends further against its reserves to another borrower. Interest payments are akin to money received for a product, that is the loan, and management of the risk held by the bank in lending money.
Why does the money supply decrease when interest rates increase?
It turns out that bank deposits are classed as liabilities and so loan repayments are treated as liabilities and so the money supply increase is indeed reducing. However, all is not as it seems because the interest on the loan is not a repayment but a fee and so will find its way through the pl account into the bank’s reserves.