How Money Gets Created

The modern economy relies on money being abundant and freely circulating, as both households and corporations depend on it to service debts and fund their day-to-day operations.

But where does money come from? This post explores the mechanics of how new money is created in the economy. It is specific to the United States, but the underlying mechanics are effectively the same in many countries.

Bank deposits and reserves

Let’s briefly cover how the banking system is structured given its importance in the monetary system. Commercial banks operate under a central bank that oversees monetary matters and liquidity conditions in the market. The central bank functionally serves as the bank for the commercial banks. In such a system, there are two distinct types of money: bank money and consumer money. Bank money refers to deposits held by commercial banks at the central bank, known as bank reserves. Consumer money refers to the money individuals and corporations see in their accounts at commercial banks, known as bank deposits.

Bank reserves stay closed in the banking system, used primarily to settle payments between banks and to meet regulatory requirements. Bank deposits, on the other hand, are used by individuals and corporations for everyday transactions, savings, and payments.

What most people think of as money is the bank deposit and cash available to them to spend in the economy. So how is this form of money created in the first place? You might be surprised to learn that most of the money creation today is done through bank lending. It is the primary channel for expanding bank deposits in the system.

Bank’s balance sheet

When someone deposits money into their account at a bank, they are effectively lending that money to the bank, becoming an unsecured creditor of the bank. The bank, in turn, allows the depositor to claim an equivalent amount against the bank. The deposit increases the bank’s assets and simultaneously creates a matching liability, since the bank owes that amount to the depositor.

As an example, consider Elise, who makes a deposit of $10,000 at Bank A. The transaction results in the following changes on the balance sheet:

In this situation, there is no net effect to the money supply (deposits and currency in circulation). Now let’s take a look at what happens when a bank makes a loan.

Bank lending creates new money

Consider Marco, who takes out a loan of $20,000 from Bank A.

Here the bank, in exchange for the debt security, credits Marco with new demand deposits, effectively creating new money into existence. Notice that the bank simply digitally conjured up this new demand deposit into existence at no cost and in doing so increased Marco's purchasing power. This form of money “printing” accounts for the vast majority of the money circulating in the economy today and when credit is expanded rapidly, it acts as an inflationary force on the economy.

The chart below shows that total bank lending and total deposits across the entire banking system have expanded almost in lockstep.

Source: FRED, Federal Reserve Bank of St. Louis

You might wonder why banks are given the privilege to earn a return on money that was created from nothing. Well, if we care about growing the economy, we need some mechanism for creating the liquidity required to do so. Bank lending is that mechanism.

Constraints to bank lending

So why doesn’t a bank issue loans freely, since it can effectively just print the money for that loan at no cost? Several factors constrain how much a bank chooses to lend. The most immediate is profitability and risk of default. Banks will only extend credit when the expected return justifies the risk, and if alternative investments offer better risk-adjusted returns, capital will be allocated away from lending. For every loan a bank issues, a matching liability (the deposit credited to the borrower) is created on the balance sheet. The bank, like any other business, must be solvent to remain in operation and are thus incentivized to make loans to productive ventures. However, issuing credit is inherently risky as one assumes default risk and history has plenty of instances of credit-driven banking crises.

Bank lending is further constrained by regulations that mandate a bank maintain a certain level of capital relative to their risk-weighted assets. Given the importance of credit to economic growth, it follows that governments would use regulatory policy to encourage bank lending during periods of stagnation.

Deficit spending expands bank deposits

We’ve learned that commercial banks make up a significant portion of the money supply by issuing credit into the economy. The other important channel for expanding the supply of money is government deficit spending financed through the banking system.

The Treasury holds a special account at the Fed called the Treasury General Account (TGA) from which it conducts fiscal operations. To finance a budget deficit, the Treasury auctions government debt securities (Treasury bonds, notes, and bills) to primary dealer banks, who purchase them with bank reserves. This transfers bank reserves from the dealer bank to the TGA as shown in the T-account below.

Notice that the dealer bank’s purchase is just an asset swap, reserves for securities, with no change to its liabilities. The Treasury, on the other hand, sees both its TGA balance and its liability grow together.

When the treasury draws down the TGA by spending into the economy, it expands bank deposits i.e., creating spendable money that didn’t exist before. Take as an example the response to the COVID pandemic, where Congress passed a series of economic stimulus packages that sent payments directly to the private sector, effectively crediting millions of Americans’ checking accounts with new bank deposits. To illustrate the point, consider how the balances change when the Treasury sends a $10,000 stimulus check to a small business:

The Treasury’s spending credits the business’s checking account with new bank deposits, expanding the pool of money available to spend in the economy. Like with bank lending, when deficit spending expands deposits rapidly, it creates inflationary pressures in the economy, as evidenced by the asset price inflation in stocks, real estate, and cryptocurrencies that followed shortly after the pandemic stimulus.

Monetary aggregates

So far we’ve broadly differentiated between bank reserves (inter-bank money) and bank deposits (money spendable in the real economy). But money can be classified more granularly: cash; bank deposits (demand deposits, savings deposits, and time deposits); near-money instruments (money market funds and repurchase agreements); short-term debt securities (Treasury bills and commercial paper); and potentially in the future, central bank digital currencies and stablecoins. Economists organize these forms of money into monetary aggregates based on liquidity. The most noteworthy monetary aggregates are M0 (monetary base) and M2 (broad money).

M0 consists of:

M2 consists of:

Bank lending and fiscal deficits expand the broad M2 money supply.

Monetary metrics

Now that you understand how money is created, you can monitor these processes using publicly available data from the Federal Reserve Economic Data (FRED) database: