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 is money created?
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.
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.
What affects how much money exists in the economy?
To some extent, we all do. When lots of people borrow money, the amount of money in the economy increases. On the other hand, when many people pay off their debts, there’s less money in the economy.
The Bank of England also has an important part to play. We set the interest rate, which affects how much high street banks charge for lending money and how much interest they pay on people’s savings.
Low interest rates make it cheaper to borrow money, which means more people will do so. New money is created and people spend more, which helps the economy to grow. When we want the economy to cool down, higher interest rates encourage people to pay off debts and hold back on spending.
If lowering the interest rate fails to get the economy moving, we can also increase the amount of money through quantitative easing.
So when we set interest rates, or do quantitative easing, one of the ways they impact the economy is through affecting the amount of money in the economy.
Want to know more?
- For a more detailed explanation, read our Quarterly Bulletin article on money creation in the modern economy.
- Read the Governor’s speech about the future of money.