Final answer:
A transaction involving a loan increases a business's Undeposited Funds and an appropriate income account, which impacts the M1 money supply when these funds are deposited into a demand deposit account.
Step-by-step explanation:
A transaction increases Undeposited Funds and an appropriate income account. When a business receives money from a source like a loan, it records the loan as an increase in its Undeposited Funds account, which is an asset account, until the funds are deposited into the bank. Similarly, the loan is recorded in an income account such as 'Loan Income' or 'Other Income,' depending on the business's accounting practices. An increase in the Undeposited Funds means the business has more cash on hand that it has not yet deposited into the bank. The addition to the income account reflects the business's increased financial resources due to the loan.
In the context of money supply, when a loan is deposited into a checking account, it affects the M1 money supply, which includes checkable (demand) deposits. For example, if Jack's deposits a loan in its checking account at Second National, it instantly increases the money supply by the amount of the loan. This illustrates how bank lending can expand the money supply, with banks playing a crucial role by loaning out the funds they hold in excess of their reserve requirements.