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In a fractional reserve system when banks lend out money, that money is created out of thin air by a accounting journal entry, and the money supply goes up by the amount of the loan & when the loan gets paid off, that money disappears back into thin air and the money supply goes back down which is often also described as "destroying the money"

As under normally amortized loan, out of monthly payments, some part goes towards interest & some towards principal repayment, so the question is does the money equivalent of principal repayment disappears into thin air every time the payment is made towards principal of the loan, or does it only disappears at end of the loan term all at once when the loan has been repaid in full?

If the money gets destroyed or rather disappears from the money cycle every time the principal is repaid from the monthly payments, then does it means that the banks are only left with the interest parts & nothing out of the principal portion on their books?

Also how does the money gets depleted from the money cycle and disappears into thin air in the case of "interest only loans", where during the term of the loan only interest payments are being paid by the borrower & the principal is repaid all at once at the end of the term of loan in form of a single one time payment.

So is it that in such interest only loans because the principal gets repaid all at once at the end of the loan term so at that time immediately it gets depleted from the money cycle all at once & disappears into the thin air?

And most importantly: if all of the money equivalent of the principal amount of loans disappears then how does the banks end up recovering the actual amount loaned by them to the others & not just the interest on that loan?

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  • $\begingroup$ Not mentioned in any of the replies was the fact that when the borrower fails to pay back the loan, the bank takes ownership, though not happily, of the property the money was created and lent to buy. A house for example. In effect, the house is now a bank asset and offsets, partially, the total amount of money lent. $\endgroup$ – Red Wine Please Feb 14 '17 at 19:46
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The money is removed when the loan principal is repaid. The actual point in the loan this occurs depends on the loan terms. For a typical compound interest rate loan, this means a small portion of the principal is repaid every month, and a matching liability deposit (money in the customers account) is removed.

For an interest only loan, this occurs at the end of the loan - assuming all the principal is repaid then.

Interest payments essentially circulate through the monetary system. They're deducted from the customer's account, recognised as income by the bank, and then paid out as some form of expense, e.g. salaries, rent, taxes, etc. They may also be moved into an internal account to provide required loss provisions on loans.

Loan defaults are also an expense, and this is the achilles heel of the banking system. If defaults on loans exceed the bank's loss provisions and profits from interest, then the bank will have to write off against its capital - and this interferes with the regulatory controls on lending, causing the money supply to shrink. In practice, central bank or government intervention is inevitable if this occurs.

As far as the relationship of principal to the money supply. Essentially the banking system relies on new lending always being sufficient to replace the money being removed. In most banking systems, new lending is typically in excess of loan repayment, and so we see the money supply more or less continuously expanding.

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  • $\begingroup$ & Please ignore my lack of knowledge on this but what it means is that the reason money is removed out of the cycle is because its getting returned to the bank/lender & is taken out of the circulation, Am I right? So the question is does this principal part although gets taken out of circulation but does it remains in the accounts of the bank own & can they use the same amount received back as a principal repayment to re-lend in the future? & Wouldn't doing this put that sum of money back in the cycle / circulation again? $\endgroup$ – AndyFlip Jun 10 '15 at 5:04
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    $\begingroup$ When the principal is reduced, the corresponding deposit is removed from circulation, when a new loan is made, then a corresponding deposit is added to circulation. So the money itself doesn't remain in circulation during this process - it's being continuously removed and re-added. [Rightly or wrongly I tend to think of this part of the system as being a little bit quantum.] Economically speaking it's not just a question of semantics, since the new money is always created as part of a new loan being made, which ties it down in terms of where it's going. $\endgroup$ – Lumi Jun 10 '15 at 14:54
  • $\begingroup$ Say a bank creates a loan of USD 100 at rate of 5% for 10-years, so the net amount to be returned back by the borrower to the bank should be approx USD 127 inclusive of principal. So its well understood that when this loan is created it adds $100.00 to the money cycle but the question is that once this loan has been repaid in full, by what amount will it deplete the money cycle: 1. Will it deplete the money cycle by USD100.00 which was the principal of loan or by full USD127.00 which the borrower repaid to the bank? $\endgroup$ – AndyFlip Jun 11 '15 at 6:11
  • $\begingroup$ Also to add up to above, its obvious that the USD 27 earned as an interest on the loan by the bank will add up to the profits of the bank but what about the USD 100 which the bank received back in form of principal repayment from the borrower? How will that USD 100 be used up by the respective bank, does it adds up to banks assets, or to the pool of funds of the bank so that they could utilize the same or could lend that same amount of USD 100 ahead once again? $\endgroup$ – AndyFlip Jun 11 '15 at 6:15
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    $\begingroup$ It depletes it by 100 - the amount of the principal. The double entry book keeping operations they use are [debit loan 100, credit account 100] to make the loan, and [credit loan 100, debit account 100] to repay the principal. If the bank is within its regulatory constraints then it can issue a new loan, and recreates the deposit. Principal doesn't count as profit at all, but if the loan isn't repaid, then profits have to be used to write-off the loan. $\endgroup$ – Lumi Jun 11 '15 at 13:31
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When an unpaid loan is written off against the bookkeeping profits sitting on a bank's P&L account, the endogenous money supply (total spendable money swilling around the economy) remains unchanged - please correct me if you think I am wrong.

I'll explain this by way of an example: If I take out a loan to buy a car, every time I make a repayment my current account (spendable money) is reduced, as is the outstanding balance on my loan account with the bank - so what was spendable money sitting in my current account effectively disappears into thin air. However, when a bank writes off an unpaid loan it has made to one its customers, it doesn't reduce its own cash reserves, but instead reduces the bookkeeping profit sitting in its Profit and Loss Account - no 'spendable' bank account balances anywhere are reduced by doing this!

The net profit of a bank only becomes 'spendable' money when bookkeeping entries are made to transfer and credit it to customers' (and its own?) bank accounts.

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  • $\begingroup$ The write-off order is against loss provisions, then profits, and finally capital. Banks are typically required to maintain a certain percentage of loss provisions vs. loans, so when a new loan is made additional deposit money must be moved to loss reserve, and that reduces the effective money supply. If they write off against profits, then that money isn't recognised as income - again an effective drop, and if they have to hit capital, then the regulatory controls become problematic as they can't make a new loan - again, reducing the effective money supply. $\endgroup$ – Lumi Jun 10 '15 at 14:50
  • $\begingroup$ I agree there is a very interesting issue lurking behind all this, in whether things like loss provisions and interest income before its recognised, should be counted as part of the money supply or not. $\endgroup$ – Lumi Jun 10 '15 at 14:56
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I appreciate the order of write-off is loss reserve, profits and then capital - but reducing these balances when writing off loans does NOT 'destroy' spendable money in accounting terms. I'll explain why: in double-entry bookkeeping, moving 'money' to a loss reserve keeps it on the debit side of the ledger - the same side that the outstanding balance on a loan account sits (loans are assets to the bank). Therefore, one cannot cancel the other out. Instead, what happens is that a provision for bad debts account is created, and some of the profit sitting in the P&L is moved and credited to it. When the a loan is written-off, the accounting entries are: Debit Bad Debts Account & Credit Loan Account. Doing this does NOT diminish the quantity of 'money' in existence in the bank's accounts.

From the bank's perspective, and in accounting terms, only its customers can 'destroy' money by paying-off their loans and reducing the balances on their bank accounts. It is impossible for the bank to 'destroy' money it has created itself through the act of lending.

However, I do concede that when the bank destroys money by charging its customers interest and moving it to the P&L, that can be used later to write off bad loans - but the money is effectively destroyed when it is taken from customers' accounts.

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  • $\begingroup$ I beg to differ. It's not a question of just whether or not it's on the debit side of the ledger. Show me a money supply definition, M1, etc. that includes a loss provision ledger. Now I completely agree at the D.E.B. level this is semantics, but when economists design the regulatory controls (or at least try to reason about them), one of the controls in many countries (not the US) is the ratio of central bank reserves to customer deposits. $\endgroup$ – Lumi Jun 12 '15 at 15:42
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The creation of money occurs when the bank loans out any amount not backed by its reserves to a borrower. The borrower's debt is the excess money. 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. Interest only loans pay for the service of holding the money you and the bank created by borrowing from the bank. Then like all loans, once the payment is made, the supply of money you the borrower created is shrunk. The bank however has made money on the interest.

Over time supply and demand for loans and lending expand and contract the money supply. This coupled with the reserve rate requirements dictated by central banks dictates the supply of money in the system.

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