The profit and loss mechanism does not prevent as effectively excessive expansion and contraction in the money supply. Banks, as other private businesses, are in business to make a profit, and their chief source of income is from loans and investments. The incentive, therefore, is to keep loans and investments at the highest level consistent with safety. The demand for bank credit depends largely on the volume of business activity, rising and falling with production and trade. A rise in business activity tends to be accompanied by an increase in total commercial bank loans and purchases of securities (investments). The result is a corresponding rise in deposits and the money supply. The increase in deposits gives the borrowers more money to spend, and the total demand for goods and services expands. As long as there are unused resources, the enlarged demand tends to increase the total production of goods and services. But the expansion process does not check itself when full employment is reached. Instead, an increase in demand tends to raise prices. Either a larger physical volume of business or a rise in prices results in a larger dollar volume of business. Thus more money is needed to carry on this enlarged volume and the demand for bank credit tends to rise still further, each increase tending to generate another. As bank credit expands it does not become unprofitable to make additional loans and investments. The only restraining force is that the banker may screen his loans more carefully as the expansion continues and his reserves become low. The tendency, therefore, is for expansion to continue until checked by some external force.
A contraction in the money supply also tends to be cumulative. Borrowers usually pay off their loans and corporations retire their securities by writing checks on their deposit accounts. A general repayment of loans and securities, therefore, results in a decrease in both total deposits and total loans and investments. Thus a decline in business activity is usually accompanied by a decrease in the total volume of bank loans and investments and the money supply. Less money available for buying tends to decrease the demand for goods and services, resulting in a further decrease in business activity. Each decrease, whether in the volume of business activity or in the money supply, tends to generate a further decrease. As excess reserves pile up in the banks there is an added incentive to expand loans and investments through more liberal credit terms. Such efforts, however, are not likely to be sufficient as long as business firms find it unprofitable to borrow.