Question

“When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed.” Explain.

Short answer

The loans increase the checkable deposits and create money, whereas paying off the loans reverses the cycle and destroys the money.

Step-by-step solution

Explanation

When a commercial bank makes loans, it provides money from its reserves to the borrowers, which ultimately increases the checkable deposits in the banking system.Thus loans create money in the system.

When loans are paid off, the reverse cycle works. People withdraw from their checkable deposits and repay the loans, which increases the banks' excess reserves and reduces the checkable deposits decreasing the money supply.