Because money in modern times is merely credit, banks can and do create money out of thin air, just by making loans. When banks create money, they do so not from nothing, but by creating money from assets — and assets are anything but nothing. In modern societies, commercial banks, rather than the central bank, generate the vast majority of the money. The money supply is understood to be increased through activities of governmental authorities, national central banks, and by commercial banks.
With central bank cooperation, government may effectively fund itself by creating money. Money creation does not even need to be physical; the central bank can just envision a balance of new dollars, and then deposit it into the rest of the accounts. Real money creation happens once major banks lend these new balances out into the wider economy.
Banks are then allowed to loan a large portion of their money reserves, up to a specific limit known as a reserve requirement – which has been about 10% in the US. The central bank, according to this theory, can control the money supply by controlling the money supply, so long as the multiplier for money is limited to the required reserve ratio. For one thing, any individual banks lending activities, and thus the money creation, are limited by their central banks reserves stock, because when the borrower uses the newly obtained funds to pay a merchant who has an account with another bank, the banks that lend to them would often need to draw on reserves to cover that transaction. In addition to bank solvency representing a limit to private money creation, banks need to be able to have access to liquid reserves in order to be able to engage in money creation.
There are different ways that banks capacity to create money by borrowing is limited, meaning the notion of unlimited money creation evoked by the picture of a magical money tree is faulty. Unfortunately, the fact that the money we use is primarily issued by private banks, and that creating it involves little more than a few keystrokes, has led to the widespread, yet incorrect, belief that banks are creating money from nothing. By creating money in this way, banks have increased the quantity of money in the economy at an average rate of 11.5% per year for the past 40 years.
Banks are not simply sitting on this $100 billion plus, although they are being paid 0.25% interest now by the Federal Reserve just for parking that money with Fed banks. If The Fed wants to pump $1 billion into the wider economy, they can simply buy $1 billion worth of Treasury bonds in the markets, creating $1 billion in new money. If new money is determined to be created, the Fed targets a specific amount of the injection of money and sets up the appropriate policies.
Temporary operations are generally used to meet reserves needs deemed to be transient, whereas permanent operations are tailored to the longer-term factors driving expansions of the central bank’s balance sheet; typically, this primary factor is the trend in money supply growth of the economy.
The term money supply generally refers to the aggregate amount of safe, liquid financial assets available for households and businesses to make payments with or to hold for short-term investment.