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Money creation
The two lines written on a bank's balance sheet when it grants you a loan.
money created = new loans − repaymentsProblem / motivation
Your bank grants you €1,000. At the second the sum appears in your account, which other account has been emptied of €1,000?
The question sounds naive: the money must come from somewhere. Yet if you open the bank's books at that precise moment, you find no account debited. You find two NEW lines, entered at the same time, on either side of the balance sheet.
This course shows those two lines, then follows them to the end: what happens when you spend the money, what really stops a bank creating as much of it as it likes, and what becomes of the sum on the day you repay. The “money multiplier” mechanism, which many textbooks present, is dealt with in another course on this site: here we look at the operation as it is actually recorded.
Assumptions
In your view, which assumptions are needed for this model to hold? Jot down your ideas — no lead is wrong, this is your worksheet.
Your worksheet is still empty. Go for it: propose at least one idea.
0 idea(s) proposedFormalization
Let us take the operation again in slow motion. You sign for €1,000. The bank enters on its ASSET side a claim of €1,000 on you — what you owe it — and, in the same movement, on its LIABILITY side a deposit of €1,000 in your name — what it owes you. Both sides of the balance sheet grow by €1,000 each: the equality holds, and no third party's account has been touched. The deposit did not exist before the signature; it exists after. That is what creating money is: not moving a sum, but simultaneously entering a debt and a claim that did not exist. We say “ex nihilo” because nothing was taken — not because nothing was committed: opposite the deposit, you have committed to repay.
You still need to know which money is being talked about, because there are two, one on top of the other. Below, central bank money — also called the MONETARY BASE: banknotes, and the reserves banks hold in their account at the central bank. That money circulates only between banks — you will never see a reserve. Above, commercial bank money: your deposits, that is, lines in your bank's books. That is the one you spend, and it is by far the larger. In May 2026, out of the €11,328bn of the euro area's M1 aggregate, notes and coin weigh €1,606bn: all the rest, €9,722bn, is overnight deposits. In other words, nearly 86% of the money you can spend has never existed as an object — it was written by a commercial bank, most often by granting a loan.
Now comes the half of the story that almost no textbook tells. On the day you repay your €1,000, the bank wipes the claim off its assets and wipes the deposit off its liabilities. The two lines from earlier disappear together, exactly as they had appeared together. The money does not change hands: it stops existing. It is that symmetry which makes lending unmagical — if creation were irreversible, money could only grow, and no deleveraging could be explained.
If every new loan creates money and every repayment destroys some, then a country's quantity of money over a period is neither the total of loans nor a stock being handed out: it is a BALANCE between two flows running in opposite directions. A year in which banks grant €200bn of new loans while their customers repay €180bn creates €20bn of money — and a year in which repayments win destroys some. Click each term:
Solving / calculation
Let us follow ONE €1,000 loan through its whole life: its birth, its journey to another bank, what it really costs the bank, then its death. Each step is a balance-sheet entry, and at the end we shall check what the multiplier model would have predicted.
- 1. The granting: two lines, no transfer
ASSETS: + €1,000 (claim on you) ‖ LIABILITIES: + €1,000 (your deposit)money created: + €1,000 — the balance sheet has swollen on both sides - 2. You pay a seller who banks with bank B
bank A: deposit − 1,000, reserves − 1,000 ‖ bank B: reserves + 1,000, deposit + 1,000the money has not moved in quantity: it has changed bank - 3. What bank A must then replace
it has lost €1,000 of reserves but keeps the claim: it must refinance itself (new deposits, interbank borrowing, bonds)there is the real constraint — refinancing, not a stock of deposits to lend - 4. Reserve requirements, at last in figures
1% of the deposit created = 1,000 × 0.01 (simplified base: it excludes interbank items and liabilities of more than two years) ‖ euro area: €172bn required€10 — and against the €172bn required, banks hold €2,358bn of EXCESS liquidity - 5. The repayment: the two lines are wiped out
ASSETS: − €1,000 (the claim is extinguished) ‖ LIABILITIES: − €1,000 (your deposit)money destroyed: − €1,000 — the balance sheet returns to its size - 6. At the scale of a country, the stock is only a balance
money created = new loans − repaymentsin November 2023, M3 — the broadest aggregate, M1 plus short-term investments — FELL by 0.9% year on year in the euro area, before returning to + 0.1% in December: repayments had exceeded new loans - 7. What the multiplier really says
it assumes a euro of reserves is lent, redeposited, relent…: 1 + (1−r) + (1−r)² + … = 1/r ‖ but that sum is reached ONLY if no bank keeps idle reservesyet they keep €2,358bn of them: 1/r is a CEILING never approached, not a prediction — the ratio of overnight deposits to reserves held is 9,722 / 2,530 = 3.84
Three things to take away. (1) Creating money is not moving a sum, it is entering at the same instant a claim on the asset side and a deposit on the liability side — and repaying wipes out both: a country's money is a BALANCE between new loans and repayments, not a stock handed out. (2) What bounds a bank is not a pile of reserves: in the euro area, required reserves weigh €172bn when banks hold €2,358bn too many — nearly fourteen times the requirement. If reserves commanded lending, that mountain would already have been lent. What really bounds it is own funds, liquidity, the cost of refinancing and, above all, the number of creditworthy borrowers. (3) The multiplier model is not refuted by a computation: 1/r is a CEILING, which assumes no bank keeps idle reserves — they keep €2,358bn, and the ratio of overnight deposits to reserves held is 3.84. What disqualifies it is not a ratio, it is the DIRECTION OF CAUSATION: it is not reserves that make loans, it is loans that make deposits. The course “The money multiplier” presents that model in its own right and explains where it comes from.
money created = new loans − repaymentsSet the two FLOWS of one year — loans newly granted and repayments — and watch what follows for the stock of money. Look for the moment when money created turns negative: it is possible, and it has happened. The third slider tests the other idea of the course. At 1%, the requirement is €172bn when banks hold €2,530bn at the central bank: it does not bite. Raise the rate towards 10% and look: it would then absorb more than two thirds of the stock. So the constraint is not inoperative by nature — it is inoperative through its LEVEL.
Economic interpretation
Once the balance sheet is understood, four consequences change the way monetary news is read.
It does not ration reserves: it supplies them to whoever asks, at the price it has set. Two rates frame that price on 23 July 2026: the deposit facility at 2.25%, which remunerates the EXCESS reserves banks leave with it — required reserves, for their part, have earned nothing at all since 20 September 2023, which costs banks about €3.9bn a year — and the main refinancing operations at 2.40%, the rate at which it LENDS them, against eligible collateral. Under a regime of abundant liquidity like today's, it is the first that anchors interbank market rates. Reserve requirements do not contradict that principle: they set a RULE of calculation (1% of certain liabilities), not a ceiling on lending, and the central bank supplies without limit the reserves needed to meet it. So its lever is the COST of credit, not its volume. That is why a rise in policy rates slows money creation without any ceiling having been set: it simply makes fewer projects profitable (course “The policy rate and transmission”).
In the order in which it bites: the number of creditworthy and profitable borrowers; OWN FUNDS — the shareholders' money, the money that absorbs losses before depositors do — since every loan consumes some (a minimum of 4.5% of common equity tier 1 relative to assets WEIGHTED by their risk, plus a 2.5% buffer, 8% for all own funds together, and an unweighted leverage floor of 3%); LIQUIDITY, with a coverage ratio to be met at all times; and finally the cost of refinancing. Reserve requirements bring up the rear, a long way behind.
When you read that the central bank has “injected billions”, it has created RESERVES, which circulate between banks. That does not put a single euro more in your account: your deposit can be born only from a loan granted, or from a transfer received from somebody else. That is the explanation of the 2008-2015 puzzle: reserves multiplied several times over, a money supply that barely moved.
Because it describes a world in which reserves were scarce and therefore binding, and because it gives a sound intuition: lending spreads from bank to bank. It does, however, reverse the causation. The Bank of England wrote it in black and white in 2014 in its quarterly bulletin “Money creation in the modern economy”: banks do not act as simple intermediaries lending out the deposits entrusted to them, and they do not “multiply” central bank money. The course “The money multiplier” presents the model in its own right.
Limits / critiques
Exercises
A euro-area bank grants a mortgage of €180,000. By how much does the quantity of money held by non-bank agents rise immediately (in €)?
A loan makes a deposit of €30,000 appear. What reserve requirement does that deposit call for in the euro area, at the ratio in force (in €)?
You pay €1,000 from your loan to a seller who banks with ANOTHER bank. What happens to the total quantity of money?
True or false: when you repay the principal of your loan, the corresponding money stops existing.
Over one year, a country's banks grant €850bn of new loans; their customers repay €910bn. How much money has been created (in €bn, sign included)?
In a country, the money agents can spend is worth €800bn, of which €96bn is notes and coin. What share exists only as account entries (in %, one decimal)?
What stops a euro-area bank TODAY from granting twice as many loans?
True or false: the reserves banks hold at the central bank are part of the money you can spend.