How Do Banks Create Money?

Mainstream economics traditionally taught that banks act as intermediaries between savers and borrowers, taking deposits and lending out most of those funds while keeping a fraction in reserve (the fractional reserve banking model). However, the mainstream view has evolved, particularly after the 2008 financial crisis, to acknowledge that banks actually create money when they make loans. The Bank of England and other central banks now explicitly state that banks create deposits when they extend credit, rather than lending out pre-existing deposits. This process is constrained by capital requirements, reserve requirements, and central bank policy rates.

MMT explains that banks create money endogenously through the lending process, but emphasizes that this occurs within a hierarchy where the central bank (as agent of the sovereign) sits at the top. When a commercial bank makes a loan, it simultaneously creates both an asset (the loan) and a liability (the deposit) on its balance sheet - new money is literally keystoked into existence. However, banks need access to central bank reserves to clear payments and meet regulatory requirements. The central bank, as monopoly supplier of reserves, sets the overnight interest rate that becomes the floor for all other rates in the system. Warren Mosler and other MMT economists stress that banks don't lend reserves to customers; rather, they create deposits first and obtain reserves later if needed. The real constraint on bank lending is not the availability of reserves but creditworthy borrowers, regulatory capital requirements, and the central bank's willingness to accommodate the banking system's demand for reserves. This understanding reveals that monetary policy works primarily through interest rate effects on spending decisions, not through controlling the money supply.