Money Printing by Government, Central banks and Commercial Banks

Of Money and its Creation

Should we be worried about the value of our money and the possibility of rampant inflation? Are central banks “printing” excessive amounts of money? Are governments printing money instead of borrowing it? Are banks and fractional-reserve banking basically evil and dangerous and can they create and lend money from thin air?

Let’s explore some of these things. Maybe even with an open mind. 

But first: What do we mean by “money”?

Money certainly includes its traditional paper form which is issued by central banks. But it’s increasingly clear that most of our “money” consists of deposits in banks. Our pay cheques mostly flow electronically from our employer’s bank accounts into our bank accounts. Then we “spend” our money by transferring it to various retailers using our debit cards, or transferring it to other people using online e-transfers, or through online bill payments including pre-authorized automatic utility bill payments, or by using a credit card which we later typically pay through an online bill payment. And, although it is becoming less common, we spend our money by writing cheques, which also ultimately results in a transfer of our money to the deposit account of whoever we wrote the cheque to. 

As another example: I run a small online business. In almost 20 years of its existence that business has never collected a dime in “paper” money. Its monetary transfers include various electronic flows as well as cheques. But no paper money as such.

These days then, money consists largely (In Canada it’s over 98%!) of bank deposits but also includes the total paper money and coins in circulation. Given this, anything that increases the level of bank deposits (with the exception of deposits of existing paper money) or that increases the total amount of (paper and coin) currency in circulation increases the supply of money. 

A very interesting thing about money in the form of bank deposits is that the money one person or company or even the government spends ends up in the bank account of wherever they spent the money or sent it to.  Some money comes out in the form of paper money but even that tends to soon get deposited back into a bank account, for example when spent at a retail store. So, it’s a whack-a-mole situation. The result is that, these days, money tends to stay in banks although it is constantly flowing from one bank account to another, usually at a different bank, in millions of transactions each day. To borrow a phrase: What’s created in banks, (mostly) stays in banks.

The three key functions of money are that money is:

  1. A medium of exchange
  2. A store of value, and 
  3. A unit of account.

As discussed above, money is constantly flowing from one person or corporation or even government to another. It is its function as a medium of exchange that is its reason for existing. In order to be highly useful as a medium of exchange it has to have a reasonably stable stored value in terms of its purchasing power. And it has to be numerically quantifiable. Given those, characteristics it then constitutes a unit of account. We can count or account for the value of all the goods and services money can purchase in terms of units of money. A house is not money, but we can say that a house has a value of $400,000 for example. 

Money is an intangible concept that (as is becoming more and more apparent) has no need to exist in a physical form. Money is a value concept that allows us to trade our labours and efforts or whatever product or value we produce for any other good or service produced in the economy or to store that value for later.  Warren Buffett has described money as being a “claim check” on the goods ands services and assets of the economy. 

Who or what “backs” the value of our money?

At one time the value of money was pegged to some physical quantity of gold or silver. But that has not been the case for many years. So what “backs” our money and how can we have faith in its value?

The value of a dollar is in what it will purchase. It is the (mostly) free market that sets the prices for goods and services. Supply and demand and competition in the market place determine the purchasing power of a dollar in terms of goods and services. The number of dollars needed to purchase some things (such as houses) is also heavily influenced by interest rates. Central banks try to control the overall rate of inflation by controlling short-term interest rates and also especially more recently by purchasing bonds to control longer term interest rates.

At the end of the day, the value of our money is not “backed” by anyone or anything specifically but it retains its purchasing power fairly well in short term mostly as a result of the invisible hand of the markets and by the efforts of central banks to control inflation.

Most people will gladly accept money in payment for goods and services and will trust that its value will largely be retained in the short term. Money does tend to lose value over the longer term due to inflation. For the most part, that can be overcome through investing. While it appears that most people do trust in the value and utility of our money, each of us is free to trust or not to trust and to act accordingly.

Where does money come from?

The central bank creates (and prints or authorizes the printing of) a certain amount of physical paper money each year. Commercial banks have deposits at the central bank and they can take out some of those deposits in the form of paper money to meet any demand from their customers for paper money that is in excess of the paper money constantly flowing back into the bank such as from retailers. (In addition the banks can constantly turn in any worn out or damaged paper money and have it destroyed and replaced with new bills by the central bank, but that does not count as creating new money.)

But, as noted above, the vast majority of money consists of bank deposits and is not in the form of paper money. Today, one of the main ways, money is created is when people and businesses take out bank loans, or when the government borrows from a bank by selling it a government bond. The lending bank creates an asset on its balance sheet being a loan receivable from the borrower and simultaneously adds that amount as a deposit in the borrower’s deposit account which is a liability on its balance sheet. The bank’s net worth is unchanged and the borrower’s net worth is unchanged. The bank has taken on an asset (the loan) and a liability (the deposit). For the borrower, the deposit is their asset and the loan payable to the bank is their liability. This does add to the money supply and is in essence the creation of money (but not wealth) “out of thin air’. 

The opposite side of the above process is that when a loan is repaid the level of deposits in the banking system declines and money effectively disappears back into the thin air from whence it was created.

To understand the nature of bank lending and deposits it is necessary to be able to picture a simplified bank balance sheet. I have a short article that shows and explains the balance sheet of a small lending and deposit bank.

It may sound like this “money from thin air” process is a terrible and evil thing and amounts to the banks taking advantage of people and charging interest on money that did not cost the bank anything and seems likely to cause inflation. 

But consider the following:

1. There are limits on the “money from thin air” process including the following:

  • The total amount of loans is limited to a certain (admittedly large) multiple of the bank’s owners’ invested capital such as 12 times (which amounts to a minimum capital ratio of about 8%).

  • The bank is usually fully at risk if the borrower spends the deposited loan amount but fails to repay the loan. (Residential mortgage loans are usually an exception because the bank is covered by loan insurance.) The banks do face loan-loss risks and therefore try hard to lend only in cases where the borrower is very likely to be able to pay it back. This may be the biggest reason that lending and money creation does not usually balloon out of control.

  • The bank needs to keep some of its assets in cash (as opposed to loans) in case some borrowers withdraw their deposits. (Although the bank can easily borrow from other banks or even the central bank if needed and so this is probably no longer an important constraint although it used to be years ago.)

  • The money was borrowed for the purpose of spending and it will usually quickly be spent which will usually result in that deposit leaving the bank that created it “from thin air” and landing in a different bank. Because of this banks do have to compete to attract and retain deposits.

  • Central banks have some control over interest rates and use that and other regulatory tools to influence how much lending (and consequently money creation) banks engage in.

2. The “created from thin air” money does not belong to the bank. It strictly belongs to the borrower, in exchange for the pledge to pay it back.

3. It is the borrower, and not the bank, that typically initiates the process. It is the borrower who needed money. So, if this money creation process were evil (it’s not) then we should blame borrowers just as much as the banks.

4. This creation of money as customers borrow from banks presumably is a contributor to inflation. But it also facilitates all forms of business and the growth of the economy. If the economy and the therefore the amount of goods and services produced grows at about the same rate as the quantity of money grows then perhaps the process is not inflationary. In any case, central banks manipulate short-term interest rates with a specific goal of keeping inflation at or near a targeted level. 

Money created by government borrowing

When a bank invests in (buys) a newly issued government bond, this is the government borrowing from the bank. The federal government has deposit accounts at the large banks and the bank can credit (increase) the government’s deposit account. The government then has that money to spend but has the obligation to pay interest on the bond and to redeem it at maturity. This process creates money in exactly the same way that the commercial banking creates money when any customer takes out a loan as described above.

Central banks sometimes buy newly issued bonds directly from federal governments. The federal government has a large deposit account at the central bank. When it buys a bond the central bank credits (increases) the deposit account of the federal government which therefore has more money to spend. This creates money “from thin air” (also called printing money) just the same way the commercial banking system creates money. One difference is that central banks do not need to have any equity capital and so there is little or no limit on the amount of money a central banks can create by lending to the federal government. However, central banks have a prime responsibility to keep inflation at low levels and therefore a responsible central bank will not abuse this money creation process.

But, the government borrowing money by issuing  bonds does not always create new money. If any corporation, pension fund or individual buys a newly issued government bond using “cash” (money) that they have in an existing bank deposit account, then their deposit goes down and the government’s deposit increases and no new money is created.

How central banks buying government bonds “injects liquidity” into the system:

When the central bank buys back government bonds that are held by commercial banks that would increase the selling bank’s cash on deposit at the central bank. This is exactly what has been happening in Canada as the central bank bought government bonds starting in April 2020. Central bank deposits held by banks (members of Payments Canada) soared over 1000 fold from $250 million to $390 billion one year later.

The banks could use that cash on deposit at the central bank to invest in, for example, corporate bonds. A bank buying a corporate bond is effectively making a loan to a corporation and that does create money just as any other new loan does as described above. The added cash could also encourage the bank to make more loans. As explained above, a bank does not immediately need cash to extend new loans. But a bank would be reluctant to make new loans if its cash balance was too low since the deposit that it would create for the borrower could soon be “spent” and transferred to a different bank and the originating lending bank would need to transfer cash to that other bank as the customer’s cheque was deposited at the other bank. However, most of the time banks are probably not “cash constrained” or do not have trouble attracting new deposits to replace departing deposits and so it is not clear that this kind of bond buying by central banks would actually result in additional loans and therefore additional money in the hands of businesses and individuals. Given that banks do not seem to be cash constrained most of the time, and given that in the case of Canada over the past year the created deposits remained at the central bank, I am not clear that this injecting of liquidity (cash) onto bank balance sheets has much direct impact.

When the central bank buys back existing government bonds from pension funds, corporations and individuals that would put the money into the deposit accounts of those that are selling the existing bonds. That increases the cash money of the selling party. The central bank issues a cheque to the seller which they cash into their bank account and which ends up as an additional cash deposit of the bank in its central bank account. This would seem to be more stimulative than the central bank buying bonds from a bank because both increase the bank’s cash balance at the central banks (which does not appear to be stimulative) but this one increases the corporation’s cash as well. 

Perhaps the biggest impact of central banks buying bonds from commercial banks is not due to injecting cash onto commercial bank balance sheets but rather is the impact of lowering long-term interest rates. Lower interest rates stimulate more borrowing which, as explained above, increases the money supply. Lower interest rates are also indisputably inflationary for the prices of many assets including houses, land and equity stocks.

In summary, money is created when:

  1. People, corporations or other entities borrow from banks
  2. A bank buys a newly issued government bond. In effect this is the same as number 1, it is the government borrowing from a bank.
  3. The central bank buys a newly issued bond directly from government. This is the government borrowing from the central bank. The government can transfer the deposit created at the central bank to a commercial bank and issue cheques.
  4. The central bank buys existing government bonds from people, companies or other entities (NOT including banks).

Money is not created when:

  1.  People, corporations or other non-bank entities buy newly issued bonds from government. (Existing deposit amounts merely get transferred to government, no new deposits are created.)
  2. The Central Bank buys an existing bond from a bank. The bank gets reserves at the central bank but those are not counted as part of the money supply. This does count as injecting liquidity since the bank has added ability to make loans. But especially if the bank was not constrained in its loan making this does not directly cause the bank to make new loans and create money.


Shawn Allen
InvestorsFriend Inc.
February 25, 2021 (With minor edits to December 13, 2021 




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