No new currency is needed to pay interest on fiat currency

Often one hears claims that fiat currencies are intrinsically inflationary and ever expanding because more currency is needed in the future to pay the interest on current fiat currency.  At first glance this seems reasonable, but this is actually a specious argument.

A simple example will make this clearer.  Consider a case where an amount of currency has been created through loans, but no more will be created in the future.  Thus the money supply is constant.  Furthermore, let's assume that only the interest on these loans is paid by the borrowers so that the loans themselves will never be paid back, and the money supply will stay constant.

In this case, the interest to pay on the loans must come from the available money supply, which we've already said is fixed in amount.  So, if the claims about needing an ever expanding money supply are correct then this system will quickly grind to a halt as no more currency is being created.  For this to happen the banks would need to hoard all the interest that they receive and never pay it out in any way into the economy.  By doing this the banks would be creating a deflation in the economy as the amount of currency in circulation is ever decreasing as the interest is paid to the banks year after year.  In effect, the banks are increasing their reserves by this hoarding action.

In reality, the banks that receive interest on their loans also pay out those funds in the form of salaries, costs, and profits.  So, the interest payments that come into the bank also go out in the same amount.  This is where the funds for paying the interest comes from.  The interest payments simply circulate in the economy with payments made to the banks as interest and the funds spent back into the economy by the banks.

In a real banking system, as we have in the US, banks are required to hold reserves by regulation at the Federal Reserve.  Moreover, the Fed provides these reserves to the banks. The banks could increase or decrease their reserves as previously mentioned and this would change the money supply in circulation.  But banks have little incentive to increase their reserves as this would reduce the amount they can lend and the resulting interest payments they receive.  Changes in the money supply are closely monitored by the Fed and it acts through its open market operations to influence the money supply by buying or selling assets in the market.  So, there are always funds to pay interest on fiat currency.  The amount of funds may vary according to reserves held by banks and the Fed actions, but nothing is specifically expansionary in the money supply due to interest payments alone.