If you default on debt why does the money supply contract? If I borrow $100 from the central bank, then spend it into the economy and then tell the central bank I default, I can't pay the money back, than that is $100 extra in the system that will never be taken out. Correct? If I had paid the money back then the money would be back at the fed and therefore not circulating within the economy. So why is the argument made that when debt is defaulted on there is deflation because the remaining dollars become worth more?
Defaulting on debt shrinks the money supply the same way that paying back debt does, it reduces total bank credit. Of course, a default impoverishes the bank, while paying back does not.
As long as total bank credit is expanding, it doesn't cause any problems.
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The bank borrows from the central bank. So let's say the bank lends me $1000. I take the $1000 spend it on whatever I want, then tell the bank I can't pay. The $1000 is now added to the money supply, but it's not returned to the bank which would have returned it to the central bank. So there's an extra $1000 in the money supply. Right???
ecnerwal:The bank borrows from the central bank.
The bank borrows from the central bank to the extent that it can't meet liquidity demand. Otherwise, it can work on pure credit (fiat).
Elaborate on your answers. I don't understand. Where is the flaw in my reasoning from my previous post? If the bank lends money that was created from thin air and that money isn't paid back then that is extra money in the economy, that won't be sucked out. Right???
If the reserve requirement is 1%. So the bank can lend 1000$ for every $100 it has. Than if it lends me a $100 and I default, the bank goes under because it lost money. Because the bank went bankrupt, or just has less money to lend, the supply of credit shrinks and therefore the money supply shrinks. Right? Is that the logic of it?
ecnerwal: If you default on debt why does the money supply contract? If I borrow $100 from the central bank, then spend it into the economy and then tell the central bank I default, I can't pay the money back, than that is $100 extra in the system that will never be taken out. Correct? If I had paid the money back then the money would be back at the fed and therefore not circulating within the economy. So why is the argument made that when debt is defaulted on there is deflation because the remaining dollars become worth more?
I'm not very informed about this, but I'll lay out an idea for your consideration:
If I spend the $1,000 and never give it back tio the bank, there is indeed a thousand bucks out there. But if I repay the bank the thou, they can then, by the rules of fractional reserve banking, lend someone $10,000. So maybe they mean there is not deflation, but a lack of new inflation.
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Lol. Yea that is similar to the conclusion I came to in my other text. "If the reserve requirement is 1%. So the bank can lend 1000$ for every $100 it has. Than if it lends me a $100 and I default, the bank goes under because it lost money. Because the bank went bankrupt, or just has less money to lend, the supply of credit shrinks and therefore the money supply shrinks."
ecnerwal: If the reserve requirement is 1%. So the bank can lend 1000$ for every $100 it has. Than if it lends me a $100 and I default, the bank goes under because it lost money. Because the bank went bankrupt, or just has less money to lend, the supply of credit shrinks and therefore the money supply shrinks. Right? Is that the logic of it?
There is no reserve requirement anymore.
For what I have been reading, in a fractional banking system:
Paying back a loan reduces the money supply.
Defaulting does not reduce the money supply directly, since the money is still out there. But it creates a hole in the bank balance, so the bank will tend to be more carefull when lending, and that will have a deflationary effect. So its not a direct consequence, but it depends on how the bank reacts and its reaction is usually deflactionary.