How Does Money Creation Work?

Understanding what’s really behind our everyday money.

I. A Bread for… Code?

When we pay for a bread at the bakery, we hand over a banknote, a coin, or use our bank card. But in reality, we’re not giving a “good” with intrinsic value; we’re exchanging a piece of paper, or a line of code, for a tangible item.

This simple act hides a complex economic and social construct: today’s money is no longer backed by gold or a physical asset. Its value is based on trust and the mechanisms of monetary policy.

II. From Barter to Book Money

In ancient societies, exchanges were done through barter: a loaf of bread for a fish. But this system quickly showed its limits: not all goods are easily divisible, storable, or exchangeable. This is how money first appeared, initially in the form of precious goods (salt, gold, shells), then as coins minted by the state, and finally, as banknotes and scriptural money (electronic money).

The shift to fiat money was a major break. Unlike gold coins, this money derives its value from the trust placed in the issuing authority and its general acceptance. This transition accelerated with the abandonment of the gold standard in 1971, marking the definitive entry into the era of modern money.

Today, the vast majority of money in circulation is neither coins nor banknotes: it’s book money, created by commercial banks when they grant loans. In the Eurozone, this electronic money represents about 85% of all money in circulation.

III. How Do Banks Actually Create Money?

1. The Creation Process by Commercial Banks

Contrary to popular belief, the Central Bank doesn’t create all the money. It’s primarily commercial banks that do it every day:

A concrete example: Marie wants to buy an apartment for 300,000 euros. She goes to her bank for a mortgage. The bank approves her request. At that precise moment, the bank:

• Deposits +300,000 euros into Marie’s current account.
• Records +300,000 euros in its receivables (what Marie owes them).

These 300,000 euros did not exist before. The loan creates the deposit, not the other way around. This money creation happens instantly, through a simple accounting entry.

2. The Role of the Central Bank

The Central Bank’s role is different:

• It refinances banks: When a bank is short on liquidity, it can borrow from the ECB.
• It buys bonds on the markets (especially during crises).
• It issues the banknotes we use daily.

The ECB, therefore, does not directly create all the money, but it controls the conditions under which banks can create it.

IV. The Limits to Money Creation

Money creation is not unlimited. Several constraints govern it:

1. Regulatory Constraints

Required Reserves: Banks must deposit 1% of their customer deposits with the ECB. If a bank has 100 million in deposits, it must lock up 1 million with the ECB.

Solvency Ratios: Since the 2008 crisis, banks must prove they have enough capital to absorb potential losses. They must maintain a minimum ratio of 8% between their equity and the loans they have granted.

2. Practical Constraints

Leaking between banks: When Marie uses her €300,000 loan to buy her apartment, the seller might be a client of another bank. Her bank will then have to transfer these 300,000 euros to the seller’s bank. It must, therefore, have this liquidity.

Cost of financing: Banks must finance their activities. If they grant too many loans, they’ll have to borrow on the markets or from the ECB, which comes at a cost.

Risk assessment: Banks only grant loans if they believe the borrower can repay. This assessment naturally limits money creation.

3. Inflation as a Limit

If too much money is created relative to the goods available, prices rise (inflation). Historical examples show the dangers: 1920s Germany, where a wheelbarrow of banknotes was needed to buy bread, or more recently, Venezuela, where inflation exceeded 1,000,000%.

V. Monetary Policy Tools in Practice

1. Interest Rates

The ECB sets its key interest rates, currently around 2%. These rates influence the cost of loans:

• If the ECB lowers its rates, banks can borrow more cheaply and pass on this reduction to their customers.
• If it raises them, the opposite effect occurs.

2. Injecting Liquidity

During crises (2008, 2020), the ECB massively buys government and corporate bonds to inject liquidity into the economy. These programs, called “quantitative easing,” amount to thousands of billions of euros.

3. Communication

The ECB regularly communicates its future intentions. These “signals” guide the decisions of banks and investors even before measures are taken.

VI. How Is Money Measured?

Economists distinguish several “layers” of money:

• M1: Immediately usable money (banknotes, coins, current accounts).
• M2: M1 + easily mobilizable savings (time deposits of less than 2 years).
• M3: M2 + slightly less liquid investments (money market funds, short-term bonds).

The ECB mainly monitors M3, which represents the total money circulating in the European economy.

VII. Current Transformations

1. The Digital Revolution

Bitcoin and cryptocurrencies: These digital currencies operate without central banks. Bitcoin, for example, is created through a computer process called “mining.” About 10,000 new bitcoins are created daily according to pre-programmed rules.

Official digital currencies: China is already testing its “digital yuan” with millions of users. Europe is studying a “digital euro” that would allow direct payments with central bank money, bypassing commercial banks.

Stablecoins: Digital currencies like Tether or USDC claim to be backed by “real” dollars. They now represent over $150 billion in capitalization.

2. Exceptional Policies Since 2008

Since the 2008 financial crisis, central banks have created unprecedented amounts of money:

• The US Fed: injected more than $8 trillion.
• The ECB: purchased over €5 trillion through its programs.
• The Bank of Japan: bought bonds equivalent to its GDP.

These amounts represent several times the annual budgets of the countries concerned.

3. Negative Rates

Between 2014 and 2022, the ECB set its rates in negative territory. Banks had to pay to deposit their money with the ECB, a historically unprecedented situation. The goal was to encourage them to lend rather than hoard.

VIII. Conclusion

Money creation, long considered a technical mechanism reserved for specialists, is becoming a central issue in contemporary economic and political debates. Understanding it helps to decode major economic developments and anticipate their impacts on our daily lives.

The ongoing transformations—digitalization, exceptional monetary policies, new actors—are redefining the contours of a centuries-old system. These changes directly affect our payment methods, our savings, and our relationship with money in general.

Mastering these issues is essential for any citizen who wants to understand current economic debates and the political choices shaping the future of our societies.

Understanding money creation is a first step. But knowing how to effectively use your money in this constantly changing context requires a personalized and professional approach.

Schedule an appointment for a personalized consultation and discover how to:

• Optimize your savings in an environment of fluctuating rates.
• Take advantage of financial innovations while controlling risks.
• Build a coherent wealth strategy aligned with ongoing developments.

Financial expertise is essential to navigate this transforming monetary landscape. Contact us to analyze your situation and define a financial strategy tailored to your goals and the current economic context.