Where Does Money Come From?

There are billions of channels for money creation, but two main ones are central banks (which issue the physical currency of a nation and define its monetary policy) and commercial banks (which create digital money whenever they issue a credit). Almost all money in the economy today is created by humans (no, not governments, but commercial banks).

Most people assume the government prints money, and then it flows out from there. Well, the truth is way more complex—and so much more interesting. We need to know how banks operate; we need to understand the source of currency value and why the money supply can grow or shrink with not a single new bill being printed.

This post unpacks the whole picture from commodity money to fractional reserve banking to how central banks work and what happens if too much—or not enough—money gets created.

What Was the Origin of Money?

This was the time before money, when barter — trading goods and services directly — was all there was. A farmer might barter their grain for a blacksmith's tools, but this system would only function when the two actually desired just what the other had. This is known to economists as the "double coincidence of wants," and this made large-scale trade incredibly inefficient.

Commodity money solved this problem. The first civilized societies established a medium of exchange based on universally valued goods—cattle, grain, salt, and later precious metals. Due to their durability, portability, divisibility, and scarcity, gold and silver dominated. They held intrinsic value — the metal itself had worth.

Eventually, it became impractical to carry gold around. Goldsmiths started printing out paper receipts for the gold their vaults held. Instead of taking gold itself, people began trading the receipts. This was the very first iteration of paper money—and when the tie between currency and physical goods began to be cut.

What Is the Gold Standard and Why Did It End?

For most of recent history, national currencies were linked to gold reserves as part of the gold standard. With this system, a government could only print as much money as it held in the form of gold, thus limiting the money supply.

In 1971, the United States officially left the gold standard behind when President Richard Nixon finally ceased U.S. dollar convertibility to gold—an event now known as "Nixon shock." After the Bretton Woods system fell apart, most other larger economies were already heading in this direction.

With this change, civilizations stopped using commodity money. They began using fiat money instead: money underpinned by the collective will of government officials and society as a whole rather than physical resources. A US dollar is worth something because the government says so and we all agree to believe and behave as if it were true.

So how does a central bank make money?

Concrete and sovereign, sitting above all others in the monetary hierarchy, is the central bank—whether the Federal Reserve in the United States, the European Central Bank, or the Bank of England. They are the only institutions legally allowed to print cash.

Central banks have some tools to increase the money supply if they want to.

Currency Printing: The Federal Reserve can order the US Bureau of Engraving and Printing to print new currency notes. Nonetheless, cash in hand only accounts for a tiny percentage of the entire money supply.

Open market operations: In this instance, the central bank purchases government securities (such as Treasury bonds) from commercial banks. In return, those banks get reserves—basically digital money credited to their accounts at the central bank. This adds to the pool of money available for lending.

Reducing interest rates — When the cost of borrowing is lower, commercial banks are encouraged to lend more, thus indirectly increasing the money supply.

Quantitative easing (QE): This is a monetary policy in which central banks buy large amounts of financial assets to add liquidity to the financial system in times of economic downturn. The Federal Reserve used QE on a large scale during the financial crisis in 2008 and again during the COVID-19 pandemic.

Now, it is important to stress that we are not talking about the common media type of sentence like "money printing," where central banks simply give out trunks and people receive large quantities of cash in their houses. A lot of it happens this way through entries coded into computer database systems.

How Banks Create Money when They Make Loans

This is the part of the story that catches most people off guard: Most money in modern economies does not get created by central banks. This is where the name of fiat comes from, as commercial banks create it—each time they create a loan.

This is called fractional reserve banking or credit creation. Here's how it works:

If you deposit $1,000 at a bank, the bank does not place that money in a vault. With fractional reserve rules, all that a bank has to do is keep part of that deposit on hand—call it 10%—and it can lend the rest out. This means $900 is loaned to another customer, who then deposits it back in their own bank. This is how the bank retains 10% and loans out $810. And so on.

At the end of this chain, it is theoretically possible for a single $1,000 deposit to lead up to $10,000 in newly created money flowing through the economy. The money multiplier refers to this effect of an increase in cash.

This is confirmed in a 2014 research paper by the Bank of England: "The way money is created today is different from the description found in some economics textbooks. Bank lending creates deposits; this is far from true—rather than households saving and banks receiving all those deposits, then lending them out. This is a basic—and often underappreciated—truth about modern money.

How Much Money Banks are Allowed to Create

The money-creation power of banks is not unlimited. Multiple constraints keep the system stable:

→ Reserve requirements: Banks are required to hold a certain percentage of deposits as reserves. This requirement was cut to 0% in March 2020 in the US (though banks hold reserves voluntarily).

Capital Requirements: Financial institutions must hold capital that is adequate in relation to their risk-weighted assets. These are minimum thresholds set by international standards under Basel III.

Another aspect of this model is demand for loans: only when borrowers want loans will the banks create money. The money supply does not grow via this channel if businesses (or consumers) are not borrowing.

Higher interest rates make it more expensive to borrow money and therefore lead to a decrease in the demand for loans and ultimately a lower rate of money creation.

The Effect of Excess Money in the System

Inflation occurs when the money supply grows more quickly than the production of goods and services; each unit of currency acquires less value (buys less), leading to an inflationary effect.

But it is also why most central banks actually want a modest (2ish percent) rate of inflation because it incentivizes spending (and investment) rather than hoarding. However, uncontrolled creation of money can have disastrous effects.

The most extreme case in modern history is Zimbabwe, which suffered hyperinflation of an estimated 89.7 sextillion percent per month in November 2008, according to the Cato Institute. Germany had a similar episode, known as hyperinflation, when the Weimar Republic existed, with people even needing wheelbarrows of cash to buy bread.

At the other extreme, an insufficient creation of money causes deflation — declining prices that sound great until you realize they discourage spending and marketplace activity and cause recessions.

Government Spending, Then or Now?

Governments do not print money that will be used to pay expenses—at least, unfortunately not directly. So the usual process goes like this:

The government spends more than it collects in taxes.

It then sells government bonds—basically IOUs that investors buy—to make up the difference (the deficit).

Some of that number comes when the central bank buys those bonds via open market operations, printing new money to finance government spending.

Though this is not as blatantly "printing money," i.e., what the government does when it creates currency, in practice the effect will be similar. Critics contend that when central banks embark on large-scale, economy-wide purchases of government debt—as the Federal Reserve did during the pandemic—it makes fiscal policy indistinguishable from monetary policy.

Modern Monetary Theory (MMT) is a macroeconomic paradigm that became mainstream at least by 2019–2020, which claims (to put it trivially) that households are not the same as governments with respect to running out of money and—while debt matters—in monetary systems like those of the US, governments that issue their own currency cannot "run out" of money, and the primary spending limit is inflation rather than debt. MMT is highly contested among mainstream economists.

What Gives Money Its Value?

There are three reasons money has value:

Trust: People accept currency because they have faith that everyone else will as well. This shared belief is self-reinforcing.

Government Support: Fiat money is legal tender—by law, it has to be accepted as payment for debts. That provides it with a baseline floor value.

Scarcity: Central banks control the money supply to avoid hyperinflation. The foundation for a currency is due to the orderliness of what is perceived as credible central banks—that is, a commitment by a central bank regarding the purchasing power (its credibility) of the currency in global markets.

Cryptos such as Bitcoin are arguing for this algorithmic imposition of scarcity (Bitcoin is capped at 21 million coins) rather than through institutional management. Economists still argue about whether this traditional sense makes them "money."

Money: Where it Comes From these Days

The mechanics of money creation and transfer are changing due to developments in digital payments, including cryptocurrencies and central bank digital currencies (CBDCs).

According to Atlantic Council's CBDC Tracker (2024), more than 130 countries are currently exploring the development of CBDCs, which could be defined as digital versions of national currencies issued by central banks. Among major-scale pilots, China's digital yuan (e-CNY) is the furthest along.

These changes do not fundamentally change where money comes from, but they have changed how money moves, who has access to it, and how governments can monitor it and manage monetary policy.

Bottom line: Money is social technology

Money had not fallen from the heavens but developed as a method of solving economic issues. It is now produced through a layered process in which central banks lay the groundwork, commercial banks create equations based on lending — pushing supply upward — and governments push both by turning the dial on fiscal or monetary policy.

This system is important to understand, as it influences everything from mortgage interest rates to inflation, tax policies, and government responses to recessions. With this background, the next time you hear discussion of an interest rate decision (and they're coming), quantitative easing (also on its way), or a government spending debate (even closer), you'll be positioned to appreciate what is really at issue—and why.

Frequently Asked Questions

Who lends money to whom and creates the vast majority of the currency in circulation?

In modern economies, the bulk of money is created by commercial banks via the loan-issuing process. A bank creates money when it grants a loan by crediting the borrower's account with new money. The majority of money in the economy is created by banks, as acknowledged by the Bank of England, with central bank-issued cash being a smaller share.

Of course, we can make a million monetary units.

No. Governments can technically "print" money, but if you keep pumping out bills, inflation or hyperinflation (you know the one; the rapidly fading value of a currency) occurs. Central banks are partly there to limit this, independently of governments in many countries, enough to resist the political temptations of excessive money creation.

What is fiat money?

Fiat money is currency that has value simply by government decree as opposed to being backed by a physical commodity like gold or silver. Fiat currencies are most modern-day currencies, such as the US dollar, euro, and British pound. They rely on public confidence as well as the legitimacy of the national government and central bank that issues them.

Q: What is the difference between money and currency?

There are 2 aspects of money; one is currency, which is the paper notes and coins you get from a government or central bank. Money is a more encompassing term that refers to currency, bank deposits, and other financial tools used as a means of trade. Currency is all money, but money is not just currency.

What causes inflation?

Inflation is simply the outcome of an increasing money supply relative to the economy's ability to produce goods and services. This occurs if central banks create too much money, if the government spends excessively by creating new money, or if supply shocks reduce the availability of goods. Central banks also aim at moderate inflation rates of 2% or thereabouts to ensure balance between growth and price stability.

What is quantitative easing?

Quantitative easing (QE) is a monetary policy in which a central bank buys financial assets—typically government bonds—from commercial banks to add money into the system. QE builds up bank reserves and lowers long-term interest rates, inducing banks to lend/finance investment. The Federal Reserve used QE in response to the financial crisis of 2008 and again following the COVID-19 pandemic.

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