How Is Money Created?

Commercial banks create money when they issue loans by simultaneously crediting the borrower's deposit account and recording a loan asset. Governments create money when they spend by crediting bank accounts at the central bank. Neither process requires pre-existing savings or reserves.

In mainstream economics, money is created primarily through a two-stage process: the central bank (Federal Reserve) creates base money by purchasing assets or making loans, and then commercial banks amplify this through fractional-reserve banking—lending out deposits and creating credit money. Money supply is constrained by reserve requirements, the monetary base, and the central bank's policy rate. Mainstream theory treats money creation as relatively limited and mechanical: the central bank supplies base money, banks lend against reserves, and the money multiplier determines how much commercial bank money enters circulation. This framework implies that government spending is constrained by tax revenue and borrowing capacity, since the government must obtain money from savers or the central bank rather than creating it directly.

MMT reveals a fundamentally different picture of money creation rooted in the actual institutional hierarchy of modern monetary systems. As Stephanie Bell's work on 'The Hierarchy of Money' shows, government money (central bank liabilities) sits at the apex—it is created when the currency issuer spends and destroyed when it taxes. Warren Mosler's 'MMT Money Story' illustrates this vividly: money literally comes into existence when a government agent (like 'the guy's thumb at the Fed Reserve Bank in New York') credits an account. Commercial banks create money endogenously through lending, as Dirk Ehnts and Sam Levey's archive entries emphasize—following Schumpeter and Viksell, there is no mechanical limit to the quantity of money banks can create when borrowers are creditworthy. The critical insight is that government spending does not require prior tax revenue or borrowing; the government creates new money when it spends and reduces the money supply when it taxes. Banks, by contrast, create money through loans but are constrained by reserve requirements, capital standards, and the demand for credit. The sectoral balances identity ensures that government deficits equal private sector net financial asset creation—when the government deficit spends, it directly adds net financial assets (money) to the non-government sector.

Money is created in two main ways in a modern economy: commercial banks create money when they make loans, and the government creates money when it spends. Neither process works the way most economics textbooks describe. The standard story of banks lending out deposits and the money multiplier expanding a fixed monetary base is wrong, and the institutions responsible for managing money have said so explicitly.

Bank Lending Creates Deposits, Not the Other Way Around

When a bank approves a mortgage or business loan, it does not go to a vault, take out cash deposited by savers, and hand it to the borrower. Instead, the bank creates a brand-new deposit in the borrower's account by typing numbers into a computer. At the same moment, it records a loan asset of the same amount on its own balance sheet. New money has been created from nothing. The borrower has a new deposit (an asset for them, a liability for the bank) and a new loan obligation (a liability for them, an asset for the bank). The two sides of the balance sheet expand simultaneously.

This is not a fringe theory. The Bank of England published a landmark paper in its 2014 Quarterly Bulletin titled "Money Creation in the Modern Economy" that stated plainly: "Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." The paper explicitly rejected the textbook money multiplier model and confirmed that loans create deposits, not the other way around.

The Bundesbank, Germany's central bank, published a similar paper in 2017 confirming the same mechanism. The Bank for International Settlements, the central bank of central banks, has published multiple papers supporting endogenous money creation. The academic debate is settled among those who study the actual operations of the banking system. The textbooks simply have not caught up.

This means that saving does not fund lending. Banks do not wait for depositors to bring money in before they can lend it out. They lend first, and the act of lending creates the deposit. Banks are constrained by their willingness to lend (based on creditworthiness assessments and profit expectations), by capital adequacy regulations, and by the demand for loans from creditworthy borrowers. They are not constrained by the quantity of reserves or deposits they already hold.

Government Spending and Money Creation

The government creates money through a different mechanism. When the government spends, the Treasury instructs the central bank to credit the bank account of the recipient. If the government pays a defence contractor, a teacher's salary, or a social security benefit, the central bank marks up the balance of the recipient's bank. The bank's reserves at the central bank increase by the same amount. New money enters the economy.

When the government taxes, the process runs in reverse. The taxpayer's bank account is debited, and the bank's reserves at the central bank fall. Money is destroyed. This is the operational reality that where money comes from explores in depth: government spending creates money, taxation destroys it, and the deficit is the net money left in the economy.

Government bond issuance does not change this picture fundamentally. When the government sells bonds, it swaps one financial asset (reserves) for another (bonds). The private sector's total financial wealth does not change. It simply holds bonds instead of reserves. The common claim that the government "borrows money from the private sector" to fund spending gets the sequence backwards. The government spends first, creating the reserves that the private sector then uses to buy bonds.

Why the Money Multiplier Model Is Wrong

The standard textbook model says that the central bank controls the money supply by adjusting the monetary base (reserves). Banks then "multiply" this base by lending out a fraction of deposits, which get redeposited and lent again, expanding the money supply by a fixed multiple. This model implies that the central bank is in control and banks are passive intermediaries that mechanically lend out reserves.

The real world works in reverse. Banks make loans based on business decisions about profitability and risk. The act of lending creates deposits and, in aggregate, creates a demand for reserves. The central bank then supplies whatever reserves the banking system needs to settle payments and meet regulatory requirements. If it did not, the payment system would seize up. The central bank accommodates the banking system's demand for reserves after the fact. It does not control the money supply by rationing reserves beforehand.

This is why the massive expansion of reserves through quantitative easing after 2008 did not produce a corresponding expansion of bank lending or consumer price inflation. Central banks in the US, UK, Japan, and the eurozone created trillions in new reserves. Bank lending did not explode because banks were already making every loan they judged profitable. Adding more reserves did not change their lending decisions. The money multiplier predicted a massive expansion. It did not happen, because the model does not describe how the system works.

Understanding how money is actually created matters because it exposes the false constraints that dominate public debate. If banks need deposits before they can lend, then saving is a prerequisite for investment, and government borrowing "crowds out" private lending. None of this is true. Banks create the money they lend. Government spending creates the income that generates savings. The real constraints are inflation, real resources, and productive capacity, not a fixed supply of money waiting to be allocated.

The implications for public debate are profound. Politicians who say "we need to save more to invest more" have the causation backwards. Investment creates income, and income creates savings. Banks do not need prior savings to fund investment. They create the money when they lend. Similarly, politicians who claim that government borrowing "crowds out" private investment are relying on a model (the loanable funds theory) that does not describe how the financial system operates. Government spending adds income and savings to the private sector. It does not reduce the pool of available funds.

When money is repaid on a bank loan, the process of creation runs in reverse. The deposit is debited (destroyed) and the loan asset is written off. Money is destroyed just as it was created: by accounting entries. This is why paying down private debt can cause economic contraction. If the private sector is repaying debt faster than new loans are being created, the money supply shrinks, spending falls, and the economy can enter a deflationary spiral. This is precisely what happened in Japan after 1990 and across much of the developed world after 2008.

The distinction between fiat currency and commodity money matters here too. Under a gold standard, money creation was genuinely constrained by the supply of gold. Under a fiat system, where currency is created by sovereign authority and backed by the government's power to tax, those constraints disappear. The remaining constraints are real: how many workers, factories, hospitals, and engineers does the economy have? Not: how many gold bars are in the vault? Once you understand how money is actually created, the false scarcity narratives that dominate politics collapse entirely.

Explore the Sankey Diagram to visualise how money flows between the government, banks, and the private sector in a modern monetary system.

Banks create money by lending. Governments create money by spending. Neither needs pre-existing funds. The Bank of England confirmed this in 2014. Your economics textbook probably got it wrong.