Money, Bank Credit, and Economic Cycles - The Ludwig von Mises ...

The Credit Expansion Process 255events serve to establish that such a process has been set inmotion: (a) a decrease in original deposits; (b) an increase inthe desire of the public to hold monetary units outside thebanking system (i.e., an increase in f); (c) a rise in banks’ “prudence,”leading them to boost their reserve ratio, c, in orderto be able to comply with the higher average number of possiblewithdrawal requests; (d) a sudden rise in loan repaymentnot offset by an increase in loans granted; and (e) anescalation in the number of borrowers unable to return theirloans, i.e., many more defaulters.First, it is clear that if a certain sum in original deposits iswithdrawn from a bank (for instance, the 1,000,000 m.u.deposited in past illustrations), all created loans and depositssuch as we referred to in preceding examples would disappearin a chain reaction, resulting in fewer loans and deposits.If we suppose that c = 0.1 and k = f = 0, then the decrease inloans and deposits would equal 9,000,000 m.u., implying asignificant drop in the money supply, which would fall to onetenthof its prior sum. The result is severe deflation, or adecline in the amount of money in circulation, leading to areduction in the prices of goods and services, which, in theshort and medium term, further aggravates the recession ultimatelycaused in the market by all processes of credit expansion.Second, a desire of the public to keep more money outsidethe banking system produces the same effects. It provokes anincrease in f and a decline in banks’ capacity for credit expansion,which in turn brings about a recession and a monetarysqueeze.Third, a decision by banks to be more “prudent” and toincrease their reserve ratio leads to a contraction as well.Fourth, the repayment of loans produces equally deflationaryeffects (when enough new loans are not granted to at leastoffset the ones returned). Let us consider this possibility ingreater detail. We will begin by imagining a bank with c = 0.1,k = 0 and f = 0, whose borrowers pay back their loans. Theaccounting entries and balance sheet prepared when the loansare granted are as follows: