How Money Is Created

Central banks—the Federal Reserve in the United States, the European Central Bank, the Bank of England—are often misunderstood. People think they directly create most money. They don't. Central banks create "base money"—the reserves that commercial banks hold at the central bank, plus physical currency. But base money is a small fraction of the total money supply. Most money is created by commercial banks.

What central banks actually do: They set interest rates. They manage bank reserves. They provide liquidity to the banking system. They conduct open market operations—buying or selling government securities to influence the amount of reserves in the banking system. They act as lenders of last resort, providing emergency funding when needed.

Interest rates are the "price of money." When central banks raise rates, borrowing becomes more expensive. Commercial banks face higher costs to borrow reserves, so they charge higher interest rates on loans. This reduces demand for loans, which reduces money creation. When central banks lower rates, borrowing becomes cheaper, demand for loans increases, and money creation accelerates.

Central banks also set reserve requirements (though these have been reduced or eliminated in many economies). They enforce capital requirements through regulatory frameworks. They monitor the banking system for stability. But they don't directly control how much money commercial banks create through lending.

Key idea: Central banks influence money creation, but they do not do most of it themselves. They set the conditions—interest rates, reserve requirements, regulatory frameworks. Commercial banks make the lending decisions that actually create money.

This is where most money is actually created. When a commercial bank issues a loan, something remarkable happens: the loan creates a deposit.

Here's the mechanism: A borrower applies for a $100,000 loan. The bank approves it. At that moment, two things happen simultaneously on the bank's balance sheet:

• Assets increase: The bank adds a $100,000 loan to its assets.
• Liabilities increase: The bank adds a $100,000 deposit to the borrower's account.

The deposit is new money. It didn't exist before the loan was issued. The bank didn't transfer money from someone else's account. It created the deposit by creating the loan.

"The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits."— Bank of England, Quarterly Bulletin 2014 Q1

This contradicts the traditional "money multiplier" model taught in many economics textbooks. That model suggests banks receive deposits first, then lend them out. The reality is the reverse: loans create deposits.

Key idea: A loan creates new money the moment it is issued. Banks don't lend existing deposits first—the loan itself creates the deposit on the bank's balance sheet.

Newly created money doesn't matter until it circulates. When the borrower spends the $100,000 loan—paying a contractor, buying equipment, paying wages—the money enters the economy. The contractor deposits the payment in their bank account. The equipment supplier receives payment. Workers receive wages. Each transaction moves the money through the system.

Money takes different paths. Some goes to wages—workers spend it on goods and services. Some goes to business investment—companies buy equipment, expand operations. Some goes to savings—but even savings eventually get spent or invested. The key is that money moves. It changes hands. It facilitates transactions.

Money velocity—the speed at which money circulates—matters. Money that sits idle in a bank account doesn't affect prices or economic activity. Money that moves quickly through the economy has more impact. If everyone hoards money, the economy slows. If money circulates rapidly, economic activity increases. Velocity is a measure of how actively money is used, not just how much exists.

Key idea: Money must circulate to matter. Newly created money enters the economy through spending, wages, and business investment. The faster it circulates, the greater its economic impact. Money that doesn't circulate is effectively inert.

Banks cannot create money without limits. Several factors constrain the process, operating simultaneously to prevent excessive money creation that could destabilize the economy.

Capital requirements: Banks must maintain minimum capital ratios under the Basel III framework. Capital acts as a buffer against losses. If a bank has $10 million in capital and must maintain a 10% capital ratio, it can only have $100 million in risk-weighted assets (including loans). This limits how much banks can lend relative to their capital. Federal Reserve research confirms that capital requirements directly constrain bank lending and money creation.

Risk assessment: Banks evaluate borrower creditworthiness before lending. They assess ability to repay, collateral value, and economic conditions. They won't lend to everyone. Risk assessment limits money creation because banks must be confident they'll be repaid. During economic uncertainty, banks become more cautious, reducing lending and money creation.

Regulation: Reserve requirements (though reduced or eliminated in many economies), liquidity requirements, and regulatory oversight all constrain lending. Banks must comply with multiple regulatory frameworks that limit their lending capacity. Regulatory constraints work alongside market forces to prevent excessive money creation.

Demand for loans: Market forces matter. If borrowers don't want loans, or if interest rates are too high, money creation slows. Banks can only create money if someone wants to borrow. During economic downturns, demand for loans decreases, reducing money creation regardless of bank willingness to lend.

Key idea: Money creation is constrained by confidence, not just policy. Banks must assess risk, maintain capital, and respond to market conditions. These constraints are as important as regulatory requirements. The system has built-in limits that prevent unlimited money creation.

Government spending injects money into the economy differently than bank lending. When the government spends—on infrastructure, services, or transfers—it doesn't require loan repayment in the same way. The mechanics are fundamentally different from commercial bank lending.

Governments finance spending through taxes or borrowing. When they borrow, they issue Treasury bonds. These bonds are sold to investors, including commercial banks and the central bank. The government receives money from bond sales, which it then spends. This spending injects money into the economy—paying contractors, employees, and beneficiaries.

The mechanics differ from bank lending: Government spending doesn't create deposits in the same way commercial bank lending does. It transfers existing money (from taxes or bond sales) or creates new money through different channels (when the central bank purchases bonds, for example). Government spending affects money creation, but through different mechanisms than commercial bank lending.

Governments don't operate like households. They can run deficits—spending more than they collect in taxes—because they can issue bonds. They don't face the same borrowing constraints as individuals or businesses. This doesn't mean deficits are unlimited, but it means government spending mechanics differ from private sector spending.

Key idea: Governments inject money differently than banks. Government spending doesn't require loan repayment, operates under different constraints, and affects money creation through different mechanisms. Understanding this distinction is crucial for understanding the complete money creation system.

Quantitative easing (QE) is often misunderstood. People think central banks "print money" and give it away. That's not what happens. QE is an asset swap—the central bank purchases assets (usually government bonds) from commercial banks. In exchange, it credits the banks' reserve accounts. This is an exchange, not a gift.

QE increases bank reserves, but reserves aren't the same as money in circulation. Reserves are deposits that commercial banks hold at the central bank. They're not directly spendable by the public. Banks may use reserves to lend (creating money) or they may hold them. During periods of economic uncertainty, banks often hold excess reserves rather than lending them out.

QE changes where money flows. When central banks purchase bonds, they increase demand for those assets, raising their prices and lowering their yields. This makes other assets more attractive. Banks and investors may use the proceeds to buy stocks, real estate, or other assets. This is why QE often inflates asset prices before it affects wages or broader economic activity.

QE has limits. It can't force banks to lend if they don't want to. It can't force borrowers to borrow if they don't want to. It changes the composition of assets in the system, but it doesn't guarantee increased money creation or economic activity.

Key idea: QE changes where money flows, not whether money exists. It's an asset swap that increases bank reserves, which may or may not lead to increased lending and money creation. The effects depend on how banks and borrowers respond.

Just as money is created, it can be destroyed. The process works in reverse. Money creation and destruction are two sides of the same mechanism—balance sheet operations.

When a borrower repays a loan, the deposit is destroyed. The bank's balance sheet contracts: the loan (asset) decreases, and the deposit (liability) decreases. Money that existed no longer exists. If the borrower had a $100,000 loan and repays it, the $100,000 deposit is extinguished. The money supply decreases by $100,000.

When loans default, money is also destroyed. The bank writes off the bad debt, reducing its assets. The corresponding deposit (if it existed) is effectively destroyed. The bank takes a loss, but the money that was created when the loan was issued no longer exists in the system.

Credit contraction—when banks reduce lending or when more loans are repaid than new loans are issued—results in net money destruction. The money supply shrinks. This can happen during economic downturns, when banks become more cautious and borrowers pay down debt. The money creation process reverses, reducing the total money supply.

"As loans are repaid, the money created is effectively destroyed, reducing the money supply."— Bank of England

Money destruction is less visible than money creation. People notice when money is created (new loans, spending increases). They notice less when money is destroyed (loan repayments, defaults). But both processes happen continuously, affecting the money supply in both directions.

Key idea: Money is destroyed the same way it is created: through balance sheets. Loan repayment and defaults reduce the money supply just as loan issuance increases it. The money creation system is dynamic, with money constantly being created and destroyed.

Inflation is not simply "too much money." It's an imbalance between supply and demand. Money creation alone doesn't cause inflation without corresponding factors. If money is created but supply increases to match (more goods and services produced), prices may not rise. If money is created but demand doesn't increase (people don't spend), prices may not rise.

Inflation happens when money creation outpaces supply growth, or when demand increases faster than supply can respond. It's a system outcome, not a simple cause-effect relationship. Multiple factors interact: money creation, supply constraints, demand changes, expectations, and time lags.

Supply constraints matter. If money is created but production capacity is limited, prices rise. If supply can expand to meet increased demand, prices may remain stable. Supply constraints—from resource limitations to production bottlenecks—affect how money creation translates into price changes.

Prices rise unevenly. Some sectors see price increases first (assets, commodities). Others see increases later (wages, services). This unevenness reflects different supply and demand dynamics across sectors. Asset prices often respond faster than consumer prices, which is why QE can inflate asset prices before affecting broader inflation.

Time lags exist between money creation and price effects. Money creation today may not affect prices for months or years. The relationship is not immediate. Expectations also matter—if people expect inflation, they may adjust behavior in ways that contribute to inflation.

Key idea: Inflation is not a switch—it's a delayed response. It results from imbalances between supply and demand, not just money creation. The timing and magnitude vary by context. Understanding inflation requires understanding the complete system, not just one mechanism.