Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region,^{[note 1]} is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is termed reserve deposits and is only available for use by central bank account holders, which are generally large commercial banks and foreign central banks. Central banks can increase the quantity of reserve deposits directly, by engaging in open market operations or quantitative easing. However, the majority of the money supply used by the public for conducting transactions is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.^[1]

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Money creation occurs when the amount of loans issued by banks increases relative to the repayment and default of existing loans. Governmental authorities, including central banks and other bank regulators, can use various policies, mainly setting short-term interest rates, to influence the amount of bank deposits commercial banks create.^[2]

The monetary authority of a nation—typically its central bank—employs control over money supply, short-term interest rates, and other tools of monetary policy to accomplish broader objectives such as unemployment reduction and price stability.^[3][4][5] Monetary policy directly impacts the availability and the cost of credit in the economy,^[6] which in turn impacts investment, stock prices, private consumption, demand for money, and overall economic activity.^[7] The exchange rate of a country's currency impacts the value of its net exports.

In most developed countries, central banks conduct their monetary policy within an inflation targeting framework,^[8] whereas the monetary policies of most developing countries' central banks target some kind of a fixed exchange rate system.^[9] Central banks operate in practically every nation in the world, with few exceptions. There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa, which all have a common central bank, the Bank of Central African States; or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the European Central Bank. Central banking institutions are generally independent of the government executive.^[2]

Central banks usually conduct monetary policy either through administratively setting interest rates or through open market operations.^[10] Lowering interest rates or purchasing debt (resulting in an increase in bank reserves) is called monetary expansion or monetary easing, whereas the opposite is known as monetary contraction or tightening. An extraordinary process of monetary easing is denoted as quantitative easing, whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

Whereas central banks can directly control the issuance of physical currency, the question to what extent they can control broad monetary aggregates like M2 by also indirectly controlling the money creation of commercial banks is more controversial.^[25] According to the money multiplier theory, which is often cited in macroeconomics textbooks, the central bank controls the money multiplier because it can impose reserve requirements, and consequently via this mechanism also governs the amount of money created by commercial banks.^[25][26] Most central banks in developed countries, however, have ceased to rely on this theory and stopped shaping their monetary policy through required reserves.^[25] Benjamin Friedman explains in his chapter on the money supply in The New Palgrave Dictionary of Economics that the money multiplier representation is a short-hand simplification of a more complex equilibrium of supply and demand in the markets for both reserves (outside money) and inside money. Friedman adds that the simplification will work well or badly "depending on the strength of the relevant interest elasticities and the extent of variation in interest rates and the many other factors involved".^[3] David Romer notes in his graduate textbook "Advanced Macroeconomics" that it is difficult for central banks to control broad monetary aggregates like M2.^{[27]: 607–608}

Monetarist theory, which was prominent during the 1970s and 1980s, argued that the central bank should concentrate on controlling the money supply through its monetary operations.^[28] The strategy did not work well for the central banks like the Federal Reserve who tried it, however, and it was abandoned after some years, central banks turning to steer interest rates to obtain their monetary policy goals rather than holding the quantity of base money fixed in order to steer money growth.^{[29]: 464–465} Interest rates influence commercial bank issuance of credit indirectly, so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.^[30] By setting interest rates, central-bank operations will affect, but not control the money supply.^{[24][note 4]}

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary^[31] and because banks have been able to build up additional reserves when they were needed. Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.^[32][33][24]

The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air".^[31] The exact mechanism behind the creation of commercial bank money has been a controversial issue.

The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).^[34]

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian^[35] and Post-Keynesian analysis^[36][37] as well as central banks.^{[38][39][note 5]} The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits – but this does not and "will never impede the bank's capacity to give the loan in the first place". Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.^[40]

Bank of England told us in 2019: "Most of the money in the economy is created by banks when they provide loans.",^[41] but not every provided loan is heightening bank money amount. It depends on payment flows after given loans.^[42] (see table by Decker/Goodhart [2021] beside).