How Money Really Works, Part 2: How Money Is Created

Intro

How money is created: seven ways central banks explain it, with how each works, its first step and its limit. When a bank lends you money for a car, it creates that money, one central bank explains. Repaying the loan makes that money disappear. Part one showed what money is.

The last item answers the question part one left open: what keeps money creation in check. These points come from central banks' own explainers, bulletins and rate statistics, linked in the description.

7. Notes and coins

Number seven: notes and coins, the money you can hold, and how it reaches your wallet. Taking cash out of your account adds no new money; it swaps part of your deposit for notes. In one central bank's system, notes come from central banks, while governments are the legal issuers of coins. In another, a national mint makes the coins, and the central bank only distributes them to banks and credit unions.

Notes and coins pay no interest; a central bank's bulletin puts their rate at zero, or slightly less after storage costs. The first central bank's August twenty twenty-six figures put average interest on household overnight deposits at 0.29% a year. By our count, at that rate a thousand earns about 2.9 a year, while a thousand in notes earns nothing. A bank pays for the notes it orders from its reserves, its own account at the central bank.

A central bank's balance sheet page explains that issuing notes creates a debt, typically among its largest. To match that debt, it holds assets, mainly its government's bonds. That page shows where the process starts: banks ask for the notes that businesses and the public want. Public demand determines how much is supplied, and the central bank typically accommodates it, that bulletin says.

In normal times, the bulletin adds, the central bank does not fix how much money circulates. Who issues coins, cash rules, monetary systems and figures differ where you live. Next time you withdraw cash, check that your balance falls by exactly the amount you hold. Subscribe, because next we explain the money only banks can hold and how it moves payments.

Number six is that money, the kind banks use to settle payments with each other.

6. Central bank reserves

Number six: central bank reserves, a kind of money one central bank says only central banks can issue. You cannot hold reserves yourself: with very few exceptions, only banks can hold an account at a central bank. Another central bank describes reserves as the deposits banks keep with it, created electronically. Banks use them to settle payments with each other and to meet customer withdrawals.

When you pay someone at another bank, your bank can settle by sending some of its reserves. The receiving bank gains those reserves; the central bank's total stays the same, only the accounts change. So reserves are the money banks pay each other with, while deposits are the money you pay with. That central bank requires banks to hold reserves of 1% of certain liabilities, mainly customer deposits.

By our count, that is ten in reserves for every thousand of covered liabilities, such as deposits. The rule is met on average over a period of six to seven weeks, not every single day. Its page shows the first step: reserves are created when it lends to banks or buys assets. To borrow them, a bank must pledge collateral, such as marketable assets or loans it has made.

Banks also keep some reserves as a buffer against a sudden need for funds, the first central bank says. Reserves cannot be lent on to you, and in normal times they do not cap how much banks lend, a bulletin explains. Reserves rules, monetary systems and figures differ where you live. On your own central bank's site, look for whether it sets minimum reserves, and at what rate.

Number five shows how a central bank can create reserves and deposits at the same moment. Number five: central bank asset purchases, the tool one

5. Central bank asset purchases

central bank turns to when its rate is already very low. These purchases are not printing cash; that central bank pays for the bonds with reserves it creates. Often called quantitative easing, it means a central bank buying government bonds, that page explains. Another central bank turned to it after the financial crisis, once it had cut its rate to half a percent.

That policy rate steers what banks pay on savings and charge on loans, and it had reached its floor. In its example, a pension fund sells a bond, and the fund's bank credits it with a new deposit. The central bank pays that bank with new reserves, so one purchase creates two kinds of money at once. If the seller is itself a bank, only reserves rise, a third central bank's report adds.

Buying bonds raises their price and lowers their yield, which can make borrowing cheaper, including some mortgages. The opening move, the first central bank's page shows, is a reverse auction, an offer to buy bonds at the best price. In one system, the rules require buying from investors in the market, not directly from governments. It is not meant to be permanent; selling or not replacing the bonds later shrinks those reserves again.

Nor are the new reserves a gift to banks: they come with a matching deposit the bank typically pays interest on. Whether this tool is used, its rules, monetary systems and figures vary where you live. Find your central bank's balance sheet page and see whether its bond holdings are growing or shrinking. Number four is the same move made by an ordinary bank, and it creates money too.

Number four: a bank buying a bond from a customer,

4. Banks buying bonds

another way one central bank says deposits are created. Banks create money not only when they lend, but also when they buy an asset from someone outside the banking system. The bank pays by crediting the seller's account, so a deposit appears that did not exist before. In that central bank's sketch, the seller's bond turns into a deposit, and the bank's books grow on both sides.

Another central bank's report says banks buy assets, mainly securities, on quite a substantial scale. Unlike a loan, nothing has to be repaid: the sale is final, though the seller can withdraw the deposit anytime. Banks often hold government bonds as liquid assets they can sell quickly for central bank money. The same report adds that payments for exports create deposits too, when a firm is paid for goods sold abroad.

It starts with the bank's own choice, as part of its trading and investment, that report shows. Sellers come from outside the banking system, such as a household, a company or the government. The reverse also holds, since a bank selling a bond to a customer shrinks the buyer's deposit. Money also shrinks when investors pay for a bank's own long-term bonds or shares with deposits.

By size, loans still lead: that report calls them the most important money-creating transaction. Which assets banks may hold, monetary systems, rules and figures vary where you live. In any bank's published balance sheet, find securities listed among its assets, along with loans. We are halfway.

Before the next one, one thing makes every item easier: each new deposit has a matching entry on a bank's books. Number three is the biggest source of new money in that report: a bank making a loan.

3. A new bank loan

Number three: a bank making a loan, which one central bank calls the principal way deposits are created. Saving more does not, by itself, give banks more to lend, that central bank explains. When households save more, those deposits simply come out of money that would have gone to firms as payments. Instead, the loan itself creates the money: the bank credits the borrower's account with a new deposit.

Deposits are simply a record of what a bank owes its customers, not an asset it can lend out. Another central bank's August twenty twenty-six figures put average interest on new home loans to households at 3.6% a year. By our count, at that rate every thousand still owed costs thirty-six a year in interest. A third central bank's example follows the money: the borrower buys a machine from someone who banks elsewhere.

The deposit moves to the seller's bank, and the borrower's bank settles by handing over reserves. It begins, that report shows, with a credit check; only a positive verdict leads to the new deposit. The borrower must apply, pass that check and pay a rate that typically includes a margin for expected losses. A bank cannot lend without limit, though: it must fund each loan and settle its payments.

Lending rules, rates, monetary systems and figures differ where you live. If you have a loan, compare the day it started with the day your account balance rose. If you want the full picture on prices, the video on protecting your money from inflation is linked on screen. In one breath: cash on demand, reserves for banks, central bank purchases, bank purchases and new loans.

Number two runs the other way: what happens to that money when a loan is repaid.

2. Repaying a loan

Number two: repaying a loan, the reverse of a new loan, as one central bank describes it. Paying off a loan does not send money back to a saver; the deposit you pay with simply disappears. Banks making loans and people repaying them are the main ways deposits are created and removed, that central bank says. Your bank lowers your deposit and your loan by the same amount, so both sides of its books shrink.

That central bank's example is a credit card: each purchase adds to the loan and to a shop's deposit. When the bill is paid in full at the month's end, all the money the card created is gone. The shop keeps its takings; the card holder's account loses the same amount. It can happen down the chain: a home seller who repays an old mortgage with the sale money removes that money.

In that case, the bulletin says, consumers' balance sheets return to where they were before the loan. Banks repay too, and as they repaid another central bank's long-term loans, their extra reserves shrank. Early repayment starts with the borrower, a third central bank's report shows: it is normally their decision. Repaying takes a deposit equal to the amount, and that deposit is what gets cancelled.

On paper this changes no one's wealth: the deposit falls, and the debt falls with it. Loan terms, repayment rules, monetary systems and figures vary where you live. After your next card payment, look at your account: the balance fell, and so did what you owe. Number one ties all seven together, and it answers the question part one left open.

1. What keeps money creation in check

Number one: what keeps money creation in check, from a bank's own costs to the central bank's rate. The final brake is not reserves but interest rates: one central bank calls monetary policy the ultimate limit. Its bulletin groups the limits in three sets: the banks themselves, the people holding the money, and monetary policy. To lend more, a bank usually has to cut its loan rates, and it may lose the new deposits to rival banks.

Keeping them means paying savers more, so at some point extra lending stops paying off. Rules also limit the banks themselves: banks there must hold capital as a cushion for loans, and those rules have grown stricter. The people who receive new money can remove it again, for example by repaying their own loans. In normal times, that bulletin says, the central bank sets the rate it pays on reserves, which feeds through to loan and savings rates.

Its aim is low and stable inflation, with a target of 2% for consumer prices. By our count, at that pace, a purchase costing 1,000 today costs 1,020 next year. Loans are normally granted at the borrower's request, another central bank adds, so demand matters too. When money growth raises risks to price stability, its report shows, the central bank first adjusts policy rates.

This brake needs the central bank to be the only provider of reserves, the money banks settle with. The brake is not mechanical: that report warns against assuming a fixed link between policy and money growth. Inflation targets, capital rules, monetary systems and figures differ where you live. Look up two figures on your central bank's page: its current policy rate and its inflation target.

Recap

Number seven, cash: banks ask for the notes the public wants. Number six, reserves: created when the central bank lends or buys. Number five, central bank purchases: a reverse auction for bonds. Number four, banks buying bonds: it starts with the bank's own choice.

Number three, a loan: a credit check, then a new deposit. Number two, repayment: the borrower decides to repay. Number one, the limits: the central bank adjusts its rate. One small action today: open one official page below and read its first paragraph.

Which of the seven surprised you most? Tell us in the comments. Results vary, rules differ where you live, and this is information only, not financial advice. Next on Wealth Filings, watch part one, what money really is, linked on screen.

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