In modern economies, money is more than just coins and banknotes; it exists as digital numbers in our bank accounts, enabling complex economic interactions. Understanding how money is created, regulated, and measured is essential for grasping the broader mechanics of economic growth, inflation, and societal development. Central banks, such as the European Central Bank (ECB) and Sweden’s Riksbank, play a pivotal role in managing this process.
I’ve done my best to create a short, simple introduction that captures both the current paradigm and standards, but also the critical perspectives for a more nuanced but fair picture of money creation. It is not perfect, but I hope it gives beginners a good introduction.
What Is Money and How Is It Created?
Money can be broadly categorised into three types:
Central Bank Money – physical cash (notes and coins) and reserves held by commercial banks at the central bank.
Commercial Bank Money – digital money created by private banks when they issue loans.
Electronic Money (e-money) – privately issued digital funds used for electronic payments, like those from fintech firms.
While central banks have the exclusive right to issue physical currency, most money in circulation today is created by commercial banks through a process called fractional reserve banking. When banks receive deposits, they are only required to hold a fraction as reserves; the rest can be lent out, thereby creating new money. This system underpins what is known as the money multiplier effect.
However, in reality, bank lending is not solely determined by the accounting transactions implied by the so-called money multiplier effect. Other important factors also play a role, such as demand for credit, risk assessments, capital regulations imposed by financial authorities, and broader market behaviour. Viewing the multiplier effect in isolation overlooks the dynamic and institutionally driven aspects of the modern monetary and credit system. Since the financial crisis of 2008, we’ve seen significant changes to the economic system, changes that many still fail to fully recognise. The regulatory reforms introduced after 2008 have been extensive and fundamentally reshaped how banks operate today.
Monetary Aggregates: Measuring the Money Supply
To regulate and assess the money supply, economists use monetary aggregates, ranked by liquidity:
M0 / Monetary Base: Physical currency plus reserves at the central bank.
M1: M0 plus demand deposits (e.g. checking accounts; money at the bank you can use any time).
M2: M1 plus short-term time deposits (e.g. savings accounts with interest rates normally bound for 1, 3, or 6-month periods).
M3: M2 plus broader financial instruments such as repurchase agreements and money market fund shares. A repurchase agreement (repo) is a short-term loan where one party sells securities (e.g. government bonds) with an agreement to buy them back at a later date for a higher price, commonly used by banks and financial institutions to obtain temporary funding. Money market fund shares are investments in funds that hold safe, short-term interest-bearing assets (such as treasury bills and certificates), and are highly liquid, allowing investors to easily redeem their shares for cash.
In the euro area, M3 is the most used measure of money in circulation. As of recent years, M3 has significantly outpaced GDP growth, raising concerns about inflation and financial stability.
The charts below are from the European Central Bank and do not include any GDP data. It’s been extremely difficult to find any data on GDP’s relation to money creation. Note that it also shows the growth in percentage per year, not total volume.
This graph shows that depending on what you measure, you get different results. In August 2023, the growth rate of the deposits at the banks was very low, but if you measure money more broadly, it wasn’t as low. Source: ECB
Source: ECB
Understanding the Difference Between M3 and Total Money Creation
M3 is a broad measure of the money supply that includes physical cash, demand deposits, savings deposits, and other relatively liquid financial assets held by the public. However, M3 does not capture the full extent of total money creation, especially the money created by commercial banks through lending. In modern economies, over 90% of money is created digitally when banks issue loans, a process not fully reflected in M3, which only tracks the end state of that money (once it exists as deposits or financial assets), not the creation mechanism itself.
For example, in the UK, the Bank of England has stated that around 97% of the money in circulation is created by commercial banks through lending, with only 3% existing as physical cash. This shows that M3 and other aggregates often understate the dynamic process of money creation.
Chart 3. Total creation of money (not M3) and GDP. Source: Positive Money, The Bank of England money creation
The Central Bank’s Toolkit: How Money Supply Is Controlled
Central banks regulate the money supply to maintain price stability and support economic growth. Their main tools include:
1. Interest Rate Adjustments
By changing the policy rate (e.g. the ECB’s main refinancing rate), central banks influence borrowing costs. Higher rates discourage borrowing and slow money creation, while lower rates stimulate lending and economic activity.
2. Open Market Operations (OMOs)
Central banks buy or sell government securities in the open market. Purchases inject liquidity into the banking system, encouraging lending. Sales withdraw liquidity, curbing excessive monetary expansion. Government securities are debt instruments issued by a government to borrow money, typically in the form of bonds or treasury bills. Investors who buy them are lending money to the government in exchange for regular interest payments and repayment at maturity. They are considered low-risk because they are backed by the government.
3. Quantitative Easing (QE)
Quantitative Easing (QE) is a monetary policy tool where a central bank creates money to buy government bonds or other financial assets. Used especially during crises, QE involves large-scale asset purchases by the central bank. It expands the monetary base and pushes long-term interest rates down. The ECB used this method extensively after the 2008 financial crisis and during the COVID-19 pandemic.
4. Digital Currencies
Many central banks are exploring central bank digital currencies (CBDCs), which could offer greater control over money flows, improved financial inclusion, and increased transparency. The ECB’s digital euro project and the Riksbank’s e-krona pilot are notable examples.
Money Supply and Economic Growth
Between 2008 and 2022, the global money supply grew at a rate much higher than global GDP. For example, in the euro area, M3 expanded by more than 50% between 2010 and 2020, while GDP growth lagged behind. This divergence reflects expansive monetary policy but also raises questions about long-term inflationary pressures and asset bubbles.
Inflation, traditionally linked to excessive money supply, has been relatively subdued in recent decades, until the post-pandemic period, when supply chain disruptions and energy shocks met massive fiscal and monetary expansion. As of 2022–2023, inflation rates in the eurozone exceeded 10% in some countries, prompting the ECB to tighten monetary policy.
The Rise of Helicopter Money
One of the most debated monetary tools in recent years is helicopter money, a metaphorical term for direct monetary transfers from the central bank to citizens, without requiring repayment. Unlike traditional stimulus, helicopter money does not increase public or private debt. Although not yet implemented in its purest form, elements of helicopter-like stimulus were seen during the COVID-19 crisis through fiscal transfers financed indirectly by central banks.
In theory, helicopter money can stimulate demand directly, bypassing banks and markets. However, concerns about inflation, central bank independence, and political misuse have kept it as a largely theoretical concept, at least for now.
Why Money Creation Matters for Society
The way money is created and distributed has profound social and economic implications. Easy credit can drive inequality if it disproportionately benefits asset holders. Unchecked monetary expansion risks inflation, eroding real incomes. Conversely, insufficient money creation can stifle investment and prolong unemployment.
Monetary policy also affects housing markets, wage levels, and business investment, shaping the social fabric of a nation. In the EU, where member states share a single currency but not a unified fiscal policy, the ECB’s role is particularly complex. Balancing the needs of diverse economies within the eurozone, like Germany’s low inflation tolerance and southern Europe's high unemployment, requires delicate, data-driven policymaking.
Summery
Money is not merely a medium of exchange, it is a policy instrument, a social contract, and a driver of economic development. Central banks like the ECB and Riksbank are at the heart of this system, even though private banks have a huge role to play.
As the global economy evolves, with digital currencies, the rise of AI, interconnected supply chains, geopolitical instability, and the planetary crises, central banks will need to adapt their tools while maintaining public trust. Our financial system has never been stable, and to create long-term sustainable development for all, significant changes will be required.
This will also require recognising that money creation does not operate in isolation. It is closely linked to fiscal policy, housing markets, tax systems, and broader economic governance. The monetary and credit system is not just a technical domain, it is embedded in a dynamic, political, and institutional context that both shapes and is shaped by wider public policy.
Note: This text was originally written by me. As English is my second language and I am dyslexic, I used AI to help improve the language.