Money and the Banking System
Money is the most liquid asset in the economy, serving as a medium of exchange, a unit of account, and a store of value. This explanation shows how money is created, mostly through bank lending, how the central bank influences that creation through its policy rate, and what the money supply can tell us about inflation.
Last updated: 16 October 2026
Definition
DefinitionMoney fulfills three fundamental functions: medium of exchange (it facilitates transactions, sparing people the need to find, as in barter, someone who offers what they want and wants what they offer), unit of account (it provides a common reference for expressing prices), and store of value (it allows purchasing power to be transferred over time).
A distinction is drawn between fiat money (not convertible into gold, with no intrinsic value, accepted by convention and, for banknotes and coins, because the law requires them to be accepted in payment) and commodity money (with intrinsic value, like gold). Modern economies rest entirely on fiat money: banknotes and bank reserves are fiat money, and bank deposits are debts of the banks, payable in that money.
The money supply is measured by nested aggregates, ever broader and less liquid (euro area definitions):
M1 = banknotes + coins in circulation + demand deposits (checking accounts)
M2 = M1 + savings deposits + short-term time deposits
M3 = M2 + repurchase agreements + money market fund shares/units + debt securities with an original maturity up to 2 years
How it works
Today, most money is not made of banknotes: it consists of deposits in bank accounts. In the United Kingdom, at the end of 2013, they made up 97% of the money held by households and firms. These deposits mostly come into being when a bank grants a loan, as the Bank of England pointed out in 2014 (McLeay, Radia and Thomas). Here is how it usually works, in four steps.
- A bank lends: it creates a deposit. It records the sum lent in the borrower's account: this money did not exist before.
- The borrower spends: the deposit moves to another account, often at another bank. The seller receives the sum; if the seller banks elsewhere, the borrower's bank must pay that other bank.
- Banks pay each other with their reserves. Reserves are banks' money at the central bank; a bank that is short of them borrows some, at a rate guided by the central bank's rate.
- Repaying destroys money. When the borrower repays, a deposit equal to the sum repaid disappears along with as much debt.
A bank does not lend without limit: a loan must earn it more than it costs, in a market where banks compete. It must also limit the risk of not being repaid. Finally, the rules require it to keep enough assets that are easy to sell, and to fund part of its loans with its own funds rather than with debt. The Basel III accords thus require top-quality capital (shareholders' money and retained earnings) equal to at least 4.5% of the bank's risk-weighted assets. With a safety buffer, a margin on top of this minimum, the threshold rises to 7%: in between, the bank must limit the distribution of its profits, for example its dividends.
The central bank mainly sets a price, the interest rate on reserves, rather than a quantity: in normal times, it supplies the reserves banks ask for, at the rate it has set. In the euro area and the United States, required reserves therefore do not limit the amount of credit; they are in any case small or zero there: 1% of certain bank liabilities, mainly deposits, in the euro area since 18 January 2012, and zero in the United States since 26 March 2020.
Textbooks often describe a "multiplier": in this view, the central bank supplies reserves, and banks then lend out several times that amount. Things work rather the other way round: banks lend first, then obtain the reserves they need. The ratio between the money supply and the monetary base is therefore observed after the fact; it does not determine the quantity of money.
When the central bank buys from a party that is not a bank, it also creates deposits. For example, if it buys bonds from a pension fund, it pays reserves to that fund's bank, which credits the same sum to the fund's account. This is how the Bank of England carried out its quantitative easing: it bought mainly from financial companies that are not banks, such as pension funds and insurance companies.
When it does not go as planned
The bank run: a deposit is a promise by the bank to pay back the sum on demand, but it keeps only a small part of what it owes as reserves. If many depositors want to withdraw their money at the same time, it can run short of liquidity, because its loans will only be repaid later, even if it is sound. Recent runs, however, started from real difficulties. In September 2007, in the United Kingdom, Northern Rock, which borrowed mainly on the markets rather than from depositors, had first lost its short-term lenders; after it was announced that the Bank of England was supporting it, depositors queued outside its branches; most withdrawals, however, were made online, by phone or by post. On 9 March 2023, in the United States, the day after Silicon Valley Bank announced a loss of 1.8 billion dollars on securities sales, its customers withdrew over 40 billion dollars, and management expected over 100 billion dollars of withdrawals the next day; the bank was closed on 10 March. To prevent such panics, deposits are guaranteed: in the European Union, up to 100,000 euros per depositor and per bank. A guarantee, however, only reassures holders of the deposits it covers: in 2007, the British guarantee repaid only the first 2,000 pounds in full, and in 2023 Silicon Valley Bank relied heavily on uninsured deposits.
Multiplying the monetary base does not multiply the money supply by as much: between August 2008 and August 2014, the monetary base of the United States was multiplied by nearly five, but the M2 money supply by only 1.5, even though the central bank's purchases from parties that are not banks themselves create deposits. The quantity of reserves does not directly limit credit (Bank of England, 2014): credit depends mostly on the demand for loans from creditworthy households and firms, on banks' caution and on the interest rate.
Credit can also grow too much. A common explanation runs as follows: when banks lend freely for house purchases, the money created pushes up property prices; the home securing the loan is then worth more, which reassures lenders and encourages them to lend even more. In 14 advanced countries, from 1870 to 2008, expansions in which credit had grown most tended to be followed by deeper recessions and slower recoveries (Jordà, Schularick and Taylor, 2013). In Ireland, the share of property-related loans in banks' assets rose from less than 40% before 2002 to over 60% in 2006, while real house prices tripled between 1994 and 2006; the banking crisis followed in 2008 (report by the Governor of the Central Bank of Ireland, Patrick Honohan, 2010).
Why it matters
Understanding how money is created helps to grasp the transmission mechanism of monetary policy. The central bank issues only the monetary base; it is the banking system that creates most of the money supply, by granting loans. Mind the direction of the arrow: a bank does not wait to receive reserves before lending — it writes a claim and a deposit at the same time, then refinances itself. Loans create deposits. The Bank of England spelled this out in 2014 (McLeay, Radia and Thomas, Quarterly Bulletin): banks do not "multiply up" central bank money, and reserves cannot be turned mechanically into loans. In normal times the central bank acts through its policy rate, then supplies the reserves the system asks for.
The quantity equation MV = PY links the money supply to the price level. Mankiw uses it to present Milton Friedman's dictum that inflation is "always and everywhere a monetary phenomenon," in the sense that it can arise only from the money supply growing faster than output. In the long run, this is a necessary condition. It is not a sufficient one: if velocity and output stay roughly stable, strong money creation turns into a rise in prices of the same size; it may not do so if velocity falls.
The money multiplier in its full form is:
m = (1 + cr) / (rr + cr)
In practice, with a reserve ratio rr = 0.01 (1%) and a currency ratio cr = 0.15, one obtains m = 1.15/0.16 ≈ 7.2. This number is what the model gives, assuming that banks hold no reserves beyond the minimum. The ratio observed in the euro area is much lower: about 4.5 between M3 and the monetary base, and 2.9 between M1 and the base, at the end of August 2026. Never read it as the creating power of one euro of base: causality runs from credit to reserves, not the other way round.
Key points
Most money in circulation is deposit money created by commercial banks, not money issued by the central bank. Banknotes and coins represent only about 14% of M1 in the euro area and 12% in the United States (August 2026)
The money multiplier is neither fixed nor causal: it varies with banks' behavior (excess reserves) and households' (preference for banknotes), and it is read after the fact. In times of financial crisis, the central bank's loans and purchases swell excess reserves and the ratio drops; credit, for its part, depends on the demand for loans from creditworthy households and firms, on banks' caution and on the interest rate, not on the volume of reserves
The quantity equation MV = PY implies that if the velocity V is stable, the inflation rate is approximately: π ≈ ΔM/M − ΔY/Y. If real output Y is also constant (ΔY/Y = 0), all money creation translates fully into inflation: π ≈ ΔM/M
Much of banks' lending is long-term, while a large share of their deposits can be withdrawn at any time: this mismatch exposes banks to bank runs. Modern safety nets (deposit insurance, lender of last resort) stabilize the system, at the risk of moral hazard (protected banks may be tempted to take more risks)
Concrete example
ExamplesIn the United States, the monetary base nearly doubled between August and December 2008, mainly because of the Fed's emergency lending during the crisis, then rose further with its securities purchases (QE), until it had tripled by May 2011 (from about $850 bn to more than $2,550 bn). Yet M2 only rose moderately, so its ratio to the base, the money multiplier, dropped. Banks' massive excess reserves did not come from a refusal to lend: their total resulted from the Fed's loans and purchases, and credit depended on the demand for loans from creditworthy households and firms, on banks' caution and on the interest rate, not on the volume of reserves. This phenomenon illustrates the limits of the simple multiplier model and explains why QE did not immediately produce inflation. In the euro area, the ECB and the national central banks made about €3.4 trillion of net securities purchases between 2015 and 2022 under their asset purchase program, and about €1.7 trillion more under a program launched during the pandemic (PEPP, from 2020 to 2022). Yet inflation averaged below 1% from 2015 to 2020; it rose sharply from the summer of 2021, as the pandemic eased, up to 10.6% in October 2022, after Russia's invasion of Ukraine.
Mankiw anecdote
MankiwMankiw tells the story of the island of Yap in the Pacific, where giant stones (fei) served as money. Inhabitants did not physically move them: ownership changed through verbal agreement, as with modern deposit money. He uses this example to show that money is fundamentally a social convention, not a physical object.
Market impact
MarketsMoney creation affects the liquidity of financial markets. An accommodative monetary policy and buoyant bank lending increase the mass of liquidity seeking financial investments, which tends to raise asset prices (equities, real estate, bonds); tightening tends to have the opposite effect. Investors follow monetary aggregates (M1, M2) among the indicators of liquidity conditions; the monetary base, which mostly follows banks' demand for reserves and the central bank's securities purchases, says less. Rapid growth in M2 can signal an excess of liquidity likely to trigger future inflation and therefore a rise in rates.
This concept as guided courses
The mechanism walked through in 7 steps, with simulators and exercises.