Where does money come from?

Why “where does money come from?” is a surprisingly hard question

When you tap your card for a coffee, it feels like “money” is something you already have that simply moves from your account to the café’s. But if you ask where that money originally came from, the answers quickly diverge. Some say the government “prints it”, others that banks “lend out deposits”, and news headlines talk about central banks “printing money” whenever there is a crisis.

Modern research by central banks and economists paints a more layered picture. Different institutions create different kinds of money for different users, and most of the money we use in daily life is created not by governments but by commercial banks when they make loans. This article gives a clear, research-based map of that system so that everyday stories about “money printing” make more sense.

What actually counts as money?

Before we can answer where money comes from, we need to be precise about what we mean by “money”. Economists usually define money by its functions: it is something widely accepted as a medium of exchange, used as a unit of account for pricing, and can act as a store of value over time. Several different instruments perform these roles in a modern monetary system.

In practice, three categories matter most: cash (notes and coins), balances in bank accounts that you can spend by card or transfer, and central bank reserves, which ordinary people never see but which sit at the core of the system. Around them is a wider penumbra of “near-money” instruments that behave like money in some contexts but not others.

A simple hierarchy of money

One useful way to think about the modern system is as a hierarchy of money. At each layer, some institution issues promises that function as money to the layer below:

Central bank money: the foundation layer

At the top of the hierarchy sits the central bank. It issues two main kinds of money: banknotes and coins, which you can hold directly, and reserves, which are electronic balances that commercial banks hold in their accounts at the central bank. Reserves are the settlement asset inside the banking system: when banks owe each other money, they settle those obligations by shifting reserves.

On the central bank’s balance sheet, banknotes and reserves are liabilities, backed by assets such as government bonds, foreign exchange reserves, and loans to banks. When the central bank “creates money”, it typically does so by expanding its balance sheet and crediting new reserves or issuing new banknotes in exchange for assets.

How central banks create money

Traditionally, central banks created money through open market operations. When they buy government bonds from banks or other financial institutions, they pay by crediting the seller’s bank with new reserves. No tax revenue is needed for this transaction, and no one else’s deposits are reduced; the central bank simply records a larger asset position and a larger reserve liability.

In crises, central banks have used large-scale asset purchases—often called quantitative easing (QE)—to inject reserves into the system. They can also provide reserves via lending facilities to banks, accepting collateral in return. In all these cases, central bank money is created as a by-product of balance sheet operations.

What central bank money can and cannot do

Although central banks can expand their balance sheets, they are not free to create unlimited money without consequences. Their mandates usually prioritise price stability and financial stability. If they create too much central bank money relative to the productive capacity of the economy, they risk undermining their inflation target and confidence in the currency.

It is also important to note that central bank reserves mostly circulate between banks and the state. Reserves determine how banks settle amongst themselves, but they do not directly show up as extra spendable balances in a household’s bank account. That link is mediated by commercial banks’ lending and portfolio decisions.

Commercial bank money: how loans create deposits

When people ask “where does money come from?”, they are usually wondering how the balances in their bank account came into existence. Modern central banks now state clearly that commercial banks create new money when they make loans. The key is to follow the accounting carefully.

The textbook story vs the modern view

Older textbooks often described banks as simple intermediaries: they took in deposits from savers and then lent those deposits out to borrowers. A related story said that the central bank controlled the money supply by injecting base money, which the banking system then multiplied through “fractional reserve banking”.

Research in the last few decades, and the practical experience of central banks, has made that story look badly incomplete. In reality, banks do not need to “have the money first” in order to lend. When a bank approves a loan, it simultaneously creates a new asset (the loan) and a new liability (a deposit in the borrower’s account). The deposit is new purchasing power in the economy and counts as money.

A step-by-step loan example

To see this more concretely, imagine a household taking out a mortgage to buy a home. The high-level steps look like this:

1. The bank’s balance sheet before the loan
   The bank has existing assets (loans, bonds, reserves at the central bank) and liabilities (customer deposits, other funding). The household has some savings but not enough to buy the house outright.
2. The bank approves the mortgage
   The bank records a new loan asset on its balance sheet and simultaneously credits the borrower’s deposit account with the same amount. No one else’s deposit is reduced at this moment; the money is created as a matching asset and liability of the bank.
3. Payment to the seller and interbank settlement
   When the buyer pays the seller, the buyer’s bank transfers the funds to the seller’s bank. If the two banks are different, the buyer’s bank settles its obligation by transferring central bank reserves to the seller’s bank. The newly created deposit moves from one bank to another, but the total amount of deposits in the system stays higher than before the loan.
4. Repayments and money destruction
   Over time, the borrower repays the mortgage from their income. Each repayment reduces the outstanding loan and the borrower’s deposit. Principal repayments destroy money: the matching asset and liability shrink together on the bank’s balance sheet.

Constraints on bank money creation

The fact that banks can create deposits when they lend does not mean they can or will expand the money supply without limit. In practice, there are several important constraints. Banks need to hold enough capital to satisfy regulators, enough liquid assets and access to funding to manage withdrawals, and enough profitable lending opportunities to justify each new loan.

In addition, central banks influence the overall environment by setting interest rates, providing or draining reserves, and regulating bank behaviour. Demand from creditworthy borrowers also matters: the banking system cannot create mortgage money if no one can afford a mortgage. The result is an endogenous money supply: it responds to the needs, risks, and incentives of the system rather than being fixed from outside.

Government, deficits, and “printing money”

Governments also play a crucial role in money creation, but often in less direct ways than headlines suggest. In most countries, the government keeps an account at the central bank. When it spends—paying salaries, pensions, or suppliers—the central bank credits the relevant commercial bank’s reserve account and the bank credits the recipient’s deposit account.

Taxes work in reverse: when a taxpayer pays, their bank debits their deposit account and transfers reserves to the government’s account at the central bank. From the private sector’s perspective, government spending adds deposits and taxes remove them. The balance between the two shapes the level of net financial assets held by the private sector.

Deficits, bonds, and the role of banks

When government spending exceeds tax revenue, the government runs a deficit. It usually issues bonds to cover the difference. These bonds are purchased by banks, pension funds, insurance companies, and sometimes directly or indirectly by the central bank. The bonds are assets for the buyer and liabilities for the government.

If a commercial bank buys a government bond from the Treasury, reserves shift within the banking system but the overall structure of money does not change dramatically. However, if the central bank later buys those bonds from banks as part of QE, it pays by creating new reserves, changing the composition of the banking system’s assets and the central bank’s balance sheet.

When is fiscal policy “money creation”?

People sometimes say that governments “print money” when they run deficits. A more precise statement is that persistent deficits, especially when supported by central bank purchases of government bonds, can lead to a lasting increase in the stock of safe financial assets and, indirectly, to more deposit money in the private sector.

Whether this is inflationary depends on how that extra purchasing power interacts with the economy’s capacity to produce goods and services. In low-demand, high-slack situations, extra money and credit may raise output more than prices. In a tight economy, the same policies may produce more inflation.

Three competing stories about banking

Economists and textbooks often use three different conceptual models of what banks do. Understanding them helps explain why there is so much confusion about where money comes from.

Constraints and feedback loops in money creation

Putting the pieces together, the amount of money in an economy emerges from a complex set of feedback loops. Banks respond to interest rates, regulations, and risk. Households and firms respond to incomes, asset prices, and expectations. Governments respond to political pressures and macroeconomic conditions. Central banks react to inflation, employment, and financial stability.

It is therefore more accurate to say that the money supply is endogenous: it adjusts to the state of the economy rather than being set directly by a central authority. Policymakers try to steer this process into a corridor where inflation is stable and the financial system remains resilient, without choking off productive investment.

How much does the central bank balance sheet matter?

A useful way to visualise the relationship between central bank money and the broader money used in the real economy is to compare an illustrative “monetary base” series with a broad money aggregate such as M2. The base typically grows more slowly and remains smaller than broad money, which expands and contracts with bank lending cycles.

This chart is an illustrative example showing how broad money (such as M2) typically grows faster and to a higher level than the monetary base. For real-world data, consult official sources such as central bank statistics or FRED.

The future of money creation: CBDCs, tokenised deposits, and beyond

From time to time, new technologies prompt the question of whether we are about to reinvent money entirely. Proposals for central bank digital currencies (CBDCs), tokenised deposits, and stablecoins all suggest a more digital future, but they do not automatically change the underlying logic of money creation.

A retail CBDC, if introduced, would be a new form of central bank money that households and firms could hold directly in digital wallets. Tokenised deposits represent existing bank deposits wrapped in programmable form. Many stablecoins are claims on bank deposits or short-term securities. In all these cases, the key question remains the same: who is issuing the claim, on what balance sheet, and under what constraints?

Summary: a layered answer to “where does money come from?”

We can now give a more precise answer to our starting question. Money in a modern economy is not a single thing that comes from a single place. It is a hierarchy of promises, with central bank money at the top, bank deposits in the middle, and a range of private instruments further down.

Central banks create banknotes and reserves by expanding their balance sheets. Commercial banks create new deposit money when they extend credit and destroy it when loans are repaid. Governments influence the system through spending, taxation, borrowing, and regulation. The overall money supply emerges from the interaction of these actors with households and firms, and from the constraints of inflation, financial stability, and real economic capacity.

References & further reading

• Bank of England — “Money creation in the modern economy”
  Official explanation of how commercial banks create deposits when they lend, with balance sheet examples.
• Bank of England — “Money in the modern economy: an introduction”
  Companion article describing what counts as money and how different forms of money relate to each other.
• Bank of England KnowledgeBank — “What is money?”
  Plain-language explainer on the functions of money and the role of banks and central banks.
• Reserve Bank of Australia — “Money: what is it and how is it created?”
  Educational overview of money creation in the Australian context, including the role of the RBA and commercial banks.
• New Economics Foundation — “Where Does Money Come From?” (book)
  Detailed guide to the UK monetary and banking system, focusing on bank credit creation.
• IMF Finance & Development — “The Truth about Banks”
  Article explaining why banks are not just intermediaries of loanable funds and how they create money.
• BIS Working Paper — “The bank lending channel revisited”
  Research paper on how bank balance sheets and policy interact with credit creation.
• BIS Annual Economic Report — “The new global financial system”
  Discussion of tokenised deposits, CBDCs, and how future monetary architectures build on existing layers of money.
• Federal Reserve — “What is the money supply? Is it important?”
  FAQ on monetary aggregates and their role in the Fed’s analysis of the economy.