The Free Market Center
The Free Market Center
Within a fractional reserve banking system an interesting thing happens when borrowers repay loans. The money that was artificially created for the purchase of the note from the borrower gets expunged. As a result, the total deposits and the total quantity of money return to the original amounts—$3,500 each.
| Grower | Dealer | Bank | Money/Deposits |
|---|---|---|---|
| Pays the bank $1,175* | Not involved |
Receives $175 in interest from grower.** | Money "destroyed" by principal payment: $1,000 *** |
| Account Balance: $325. |
Account Balance: $1,750. |
Account Balance: $1,425. |
Total Money: $3,500. Deposit Liabilities: $3,500. |
* The grower pays the Bank $1,175 ($1,000 principal plus $175 interest.)
** From that amount the Bank adds $175 to its own account for the interest earned. (I have ignored operating costs.)
*** The principal payment reduces the bank's deposit liability to the grower by $1,000, which simultaneously reduces the bank's deposit liabilities and total money by $1,000.
Notice: The repayment of the loan returns the supply of money to the original level—even after the payment of interest.
Even under the fractional reserve banking system, although the quantity of money expands for the making of loans (or the purchase of customer notes), the borrower can repay the loan with interest without the ultimate quantity of money in the system having to expand.