Money is created in different ways depending on the type of money and the country or system in which it is used.
The commercial bank
Banks can lend out more money than they hold in deposits through a process known as fractional reserve banking. Under this system, banks are required to hold a certain percentage of their deposits as reserves, which are funds that can be used to meet withdrawal requests from customers. The remainder of the deposits can be used to make loans to borrowers. This means that for every dollar deposited, the bank can lend out a multiple of that dollar, depending on the reserve requirement set by the central bank.
For example, if the reserve requirement is 10%, a bank that receives a deposit of $100 can lend out $90. This can lead to a multiple expansion of the money supply, as each new loan made by a bank can also be deposited in another bank and then used to make additional loans.
This system allows banks to increase the money supply and provide more credit for economic growth, but it also increases the risk of bank runs and financial instability if too many depositors try to withdraw their money at the same time.
The central bank
Central banks are responsible for implementing monetary policy in a country, which includes the management of the money supply and interest rates. One of the main tools that central banks use to implement monetary policy is the ability to create new money.
Central banks can create new money in a number of ways, including:
- Open market operations: Central banks can buy government bonds or other financial assets from banks, which increases the amount of money that banks have available to lend. When central banks buy assets from banks, they pay for them by creating new money and depositing it into the bank’s account at the central bank. This increases the amount of money in circulation and the reserves held by banks.
- Setting interest rates: Central banks can also influence the money supply by setting interest rates, which affects how much banks are willing to lend and borrow. Lower interest rates make borrowing cheaper, which can lead to increased lending and spending, while higher interest rates can decrease borrowing and slow economic growth.
- Lender of last resort: Central banks also act as a “lender of last resort” by providing financial institutions with loans during times of economic stress, this helps to stabilize the financial system and prevent bank runs.
Central banks have the ability to create money out of thin air because they are not constrained by the same limitations as commercial banks. They are considered as an institution with a special and unique role in the economy, and they can create money with the goal of achieving specific monetary policies such as price stability, full employment, or economic growth.
It’s worth noting that the ability to create money is not without limits or consequences, Central banks are also responsible for ensuring that the money supply is consistent with the overall economic health of the country. If the money supply is increased too rapidly, it can lead to inflation, while if it is decreased too rapidly, it can lead to deflation.
The government
Governments create money in a number of ways, including:
- Printing new currency: Governments can print new banknotes and mint new coins, which are then distributed to commercial banks and made available for circulation.
- Deficit spending: Governments can also create money by running a budget deficit, which is when they spend more money than they take in through taxes and other revenues. When a government runs a deficit, it often needs to borrow money to cover the shortfall, which can be done by issuing government bonds. When the bonds are bought by investors, the government receives the money and can use it to fund its spending.
- Monetary financing: Some governments, particularly those with a sovereign currency, can directly finance government spending by creating new money and using it to purchase assets or pay for government services. This is known as monetary financing. This is a controversial policy, as it may lead to inflation if not done carefully.
It’s worth noting that the ability of governments to create money is not without limits or consequences, creating too much money can lead to inflation, which can erode the value of money and lead to economic instability. Additionally, creating money to finance government spending can also lead to higher levels of public debt, which can be a burden on future generations and limit a government’s ability to respond to economic shocks.