One of the biggest misconceptions that people have about the way banks create money is that the central bank simply prints more of it in the form of paper bills and coins. In actuality, the amount of currency circulating in the financial system amounts to just a fraction of the amount of money recorded by banks in their books. The rest is created by banks, essentially out of nothing. How do the banks do this? Here is a brief overview.
Before we take a look at this process, let us examine more closely the fundamental concept of money itself. What is money? Money is simply a theoretical concept that represents value, with paper money and coins serving as the material personification of this concept. We know that if banks or stores refuse to accept our money, then it is no more than worthless pieces of paper and bits of metal.
Depositors place their money in the bank. These deposits are recorded concurrently in the assets column as Cash in Hand and the liabilities column as Customer s Deposits (since the banks need to return the money to the depositor when he withdraws it). For the sake of clarity, let s say the total amount of deposits in the bank is $100,000.
The bank sets aside 10% of deposits in a Federal Reserve account. This amount is intended to meet their client s withdrawal requirements, since it is estimated that, under regular conditions, depositors will not take out more than 10% of their money. The remaining 90% is now open for lending to borrowers. Let s say that you borrow $10,000 from the bank. Once the loan is approved, the proceeds are deposited into your account. You can now spend the money. However, since the bank knows that you are unlikely to take out more than 10%, it can relend the $9,000 from your account as long as it keeps $1,000 in reserve. Thus, the bank has now generated new money without fresh deposits actually being made, purely through accounting. The amount of debt actually exceeds the amounts deposited in the banks, meaning the majority of money in the financial system is now actually debts.
It should be noted that as long as the bank keeps that 10% of deposit reserves, it can keep lending money even if the amount already exceeds the total deposits it has.
The problem with this system is that in order for it to keep working, people have to keep borrowing money. If a person stops borrowing money, another one must start to borrow in order to keep the money supply high. If the levels of debt go down, so does the money supply, which would risk triggering a recession. Thus, people have to take on growing levels of debt in order to keep the economy running. You can learn more about this problem by reading free online books on this topic.