How money is created
When new money is created, banks create it in two forms: as physical cash (notes and coins) and as digital money that exists only in bank accounts.
New money is created by banks: in the form of banknotes and coins, but also as invisible ‘book’ money.
Two types of banks
Broadly speaking, there are two types of banks: central banks and commercial banks. Both create money, but in different ways.
Central banks are public institutions that manage the money of a country or group of countries. Examples include: the European Central Bank (ECB) for the eurozone, De Nederlandsche Bank (DNB) for the Netherlands, and the Federal Reserve (Fed) for the United States.
Commercial banks are private, profit-driven institutions. They make money by issuing loans, offering payment and savings accounts, and providing other financial services. Examples of commercial banks in Europe include ING (the Netherlands), Deutschebank (Germany), HSBC (UK), BNP Paribas (France) and Santander (Spain).
Fig. 1 Types of banks that create money
Base money
Central banks are responsible for creating base money. This is cash money you can physically hold: coins and banknotes.
In the eurozone:
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Banknotes are printed by the central banks of eurozone countries, such as De Nederlandsche Bank (DNB) in the Netherlands. The European Central Bank (ECB) manages the total amount of banknotes in circulation in the eurozone and checks whether the national central banks are doing their job properly.
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Coins are produced by the national governments of eurozone countries. The European Central Bank (ECB) must approve the total number of coins issued. The European Commission coordinates everything related to coins.
Minting coins
The Dutch government does not mint its coins itself, but has outsourced this to the Royal Dutch Mint (KNM). The KNM is located in Houten, in a gold-coloured building called “The Dutch Vault” (De Nederlandse Kluis).
Book money
Commercial banks do not issue coins or banknotes. Instead, they create book money, which is money you cannot physically hold. This type of money is most used nowadays and comes into existence when people take out loans.
Sophie and David are buying their first home. They found a beautiful 1930s house and want to borrow €350,000 from the bank.
Upon receiving this mortgage request, the bank first examines their financial situation to assess whether the couple can repay the loan over time. Do they earn enough? Is their income stable? Do they have any debts that could cause problems?
Luckily for them, Sophie and David’s financial picture looks good and the bank approves their loan. The bank records that Sophie and David owe €350,000. At that moment, the bank creates €350,000 of commercial bank money. They can’t physically hold this money in their hands. It exists only digitally, as numbers in an account.
Shortly afterwards, the amount appears in Sophie and David’s bank account, which they use to buy their first home.
As book money is essentially an agreement, it also ceases to exist when repaid.
Fast-forward: Sophie and David have now lived in their home for six months and have fully renovated it. Every month, they repay a small part of their loan with interest. Each repayment reduces two things at the same time: the amount they owe the bank, and the amount of book money linked to that loan.
As they pay back the loan bit by bit, the bank gradually removes the same amount of money from its balance sheet. When Sophie and David eventually repay the loan in full, the €350,000 that was created no longer exists. The money disappears, because the loan that created it has been paid off.
Takeaways
- Base money can be physically held: coins and banknotes. Central banks are responsible for creating it.
- Commercial banks create money by issuing loans. This is book money, which exists only digitally (you cannot hold it, but you can see it in your banking app).
- Money created by commercial banks disappears from the economy when loans are repaid.
Sophie and David borrow €350,000 from the bank to buy their home. They use €325,000 to purchase the house and set aside the remaining €25,000 for renovations.
As part of the renovation, they hire a tiler for a €5,000 job. The tiler receives the €5,000 and decides how to use it. He puts €3,500 into his savings account and uses €900 to pay his rent through an automatic payment. He withdraws €50 in cash for his nephew’s upcoming birthday, and keeps the remaining €550 in his current account.
When was new money created in this example?