How is money created?

Most of the money in the economy is created by banks when they provide loans.
Most of the money in the economy is created, not by printing presses at the central bank, but by banks when they provide loans.

How does it work?

Money is more than banknotes and coins. If you have a bank account, you can use what’s in it to buy things, typically with a debit card. Because you can buy things with your bank account, we think of this as money even though it’s not cash.

Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.

This also means as you pay off the loan, the electronic money your bank created is “deleted” – it no longer exists. You haven’t got richer or poorer. You might have less money in your bank account but your debts have gone down too.  So essentially, banks create money, not wealth.

Banks create around 80% of money in the economy as electronic deposits in this way. In comparison, banknotes and coins only make up three percent. Finally, most banks have accounts with us at the Bank of England, allowing them to transfer money back and forth. This is called electronic central bank money, or reserves.

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Can banks create as much money as they like?

No, they can’t.

Regulation limits how much money banks can create. For example, they have to hold a certain amount of financial resources, called capital, in case people default on their loans. These limits have become stricter since the financial crisis.

Banks also risk going bust if they lend out money left, right and centre. For instance, people borrowing money will probably spend it. If they make payments to people who have accounts at other banks, their bank will need to transfer the money to that other bank by sending it some of its electronic central bank money. So if one bank lends out too much money, at some point it will not have enough electronic money in its account with us to pay the other banks.

Why can banks create money?

This system is called fractional reserve banking – and it’s been common for centuries. The idea is that most people aren’t going to need their money in the form of cash at the same time. Therefore, a bank only needs to have a fraction of the money it’s lending to people available in cash.

This also means banks can vary the quantity of money in response to changes in the economy. The alternative would be that the central bank would have to do so itself.

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