Money and Banking: How Central Banks and Banks Create Money

Added: 2026-05-23

[00:00:00]So, how is money really created? You know, it's  not just about printing up a bunch of bills.

[00:00:05]It's actually way more interesting than that. A  pretty small action by a central bank can kick off this incredible chain reaction. One that ends up  massively increasing the entire money supply. So, yeah, let's dive in and see exactly how they pull  it off. All right, so here's the big question, the puzzle we're going to solve together. How on  earth does a 200 shekel move by the central bank end up creating 1,000 shekels of new money out  of thin air? I mean, it sounds kind of like a magic trick, right? But trust me, by the end of  this, you're going to see exactly how the sausage is made. You'll get the mechanics behind this  incredible multiplication. Okay, first things first. Before we get to the action, we got to  know what we're working with. So, let's take a quick snapshot of our little model economy. This  is our baseline. You know, the before picture.

[00:00:50]All right, let's break this down. Don't worry,  it's pretty straightforward. C is the cash people are holding. R is the reserves the banks have  tucked away. And D is what everyone has in their bank accounts, their deposits. Now, the total  money supply, M. That's just the cash plus the deposits. Simple enough. But the really important  one to watch is B, the monetary base. That's the cash plus the bank reserves. For us, it starts at  1,000. Keep your eye on that number. It's going to be a key player in this whole story. Okay. So,  our economy is just ticking along and then the central bank decides it's time to step in. This  is the catalyst. They're about to do something that directly involves the commercial banks  and well, it's going to shake things up a bit.

[00:01:29]And here it is, the big move. The central  bank buys 200 shekels worth of bonds from the commercial banks. So, it's a simple trade.  The banks give the central bank some bonds and in return, the central bank gives them 200 shekels.  But here's the kicker. This is brand new money.

[00:01:45]It literally didn't exist a moment ago. Now, this  kind of action has a specific name. The source material calls it, well, in Hebrew, it's So,  let's unpack what that means for us in English.

[00:02:00]So, the translation is positive external  infusion. Positive is easy, right? It just means money is being added. But the real key word  here, the one that changes everything is external.

[00:02:14]Think about it. This isn't just shuffling money  around that's already in the system. No, no.

[00:02:19]This is brand new cash created out of thin  air and injected from the outside by the only institution that can legally do it, the central  bank. So, what happens right away? Well, those 200 shekels land directly in the commercial bank's  reserves. Boom. The reserves jump from 900 to,00.

[00:02:37]And remember our key player, the monetary base.  Since it's just reserves plus currency, it also goes up by exactly 200. Just like that, the very  foundation of our money supply has gotten bigger.

[00:02:48]And that right there is the first critical step.  The monetary base, that core amount of money that the central bank controls has just expanded from  1,00 to,200. You could think of this increase as like the seed, a small seed from which a  much much bigger tree is about to grow.

[00:03:06]But hold on, that 200 shekele bump is not the  end of the story. Not even close. It's just the beginning. Now we get to the really cool part. The  part that feels like magic, the multiplier effect.

[00:03:19]Okay, so the key concept here is something called  the deposit multiplier. See, banks don't have to keep every single dollar you deposit sitting  in a vault. They only have to hold on to a small fraction of it. That's called the reserve  ratio. The rest, they can lend it out. And here's the crazy part. When they lend it out, that loan  becomes a new deposit in someone else's account, which the bank can then lend out a piece of again  and again and again. The formula for figuring out just how big this chain reaction can get is super  simple. It's just 1 divided by that reserve ratio.

[00:03:48]So in our little example economy, the rules  say banks have to keep 20% of their deposits in reserve. So the ratio is 0.2. We plug that into  our formula 1 /2 and that gives us a multiplier of five. Now what does that mean? It means that for  every single shekele the banks hold in reserve, the system as a whole can support five shekels  in deposits. That's some serious leverage.

[00:04:11]Okay, let's do the math. Then we've got our new  bigger reserve pile of,00 shekels. Now we take our multiplier, which is five. We multiply 1,00  by 5 and we get 5,500 shekels. Wow, that's the new potential total for all deposits. Think about  that. We started at 4,500. That is a huge jump.

[00:04:31]All right, we're almost there. We've seen  the reserves go up. We've calculated the new superersized level of deposits. So now it's  time for the big reveal. Let's put all the pieces together and see what the final impact is on the  total money supply. And the calculation here is super simple. Remember the money supply M is  just deposits plus the cash people are holding.

[00:04:52]So our new multiplied deposits are 5,500. The  cash in people's pockets, that didn't change.

[00:04:57]It's still 100. You add them together and you get  a brand new total money supply of 5,600 shekels.

[00:05:04]So let's just let that sink in for a second. We  started with a money supply of 4600 and now after that one single action by the central bank and the  power of the multiplier, the total amount of money in our economy has shot up to 5600. And there you  have it. That initial 200 shekele injection from the central bank, it resulted in a total increase  of 1,000 shekels in the money supply. We've solved the puzzle. That 200 shekels was multiplied five  times over by the magic of the banking system.

[00:05:35]So, what's the big lesson here? What's the key  takeaway? Well, the fundamental principle we've just watched play out is that it all comes down  to one simple thing. Where the money comes from.

[00:05:45]And honestly, this quote from the source  material just nails it. It says, "An internal infusion doesn't change the monetary base. An  external infusion changes the monetary base."

[00:05:55]That distinction, I mean, that's everything.  It's the absolute key to understanding how money is really created. Let's really spell this  out. What we just saw was an external infusion.

[00:06:05]New money was created from the outside, injected  into the system, and that grew the monetary base, kicking off the whole multiplier chain reaction.  An internal infusion is totally different. That's just money moving around that already exists. Like  imagine you take a 100 bucks out of your wallet and deposit it in your bank account. The money  just moved from currency to reserves. The total monetary base didn't change one bit. So no new  money gets created. Understanding that difference, that's basically understanding the engine of  modern monetary policy. And all of this leads to one final really big question, doesn't it?  I mean, we've just seen how incredibly powerful this tool is. A central bank can basically  wave a magic wand and expand the money supply with a pretty small action. Now, that power is  obviously crucial for managing a modern economy, but it's also a little scary. It makes you  wonder if it's this easy to create money, what stops them from creating too much?  What's to prevent them from just printing their way into total economic chaos?  That is a thought I'll leave you with.

[00:07:06]Okay, so have you ever really stopped to think  about where money comes from? I mean, really comes from. It's not just about the government printing  presses. Not by a long shot. Most of the money in our economy is actually created every single  day right inside the banks we use. And today, we're going to pull back that curtain and see  exactly how it's done. So, that brings us to the big question, right? Can banks just create money  out of thin air? It sounds a little crazy, maybe even like something out of a conspiracy theory.  But believe it or not, it's pretty much the core of how modern banking works. And to really get  how, we've got to start with the foundation, right? So, before we can watch money multiply,  which is the exciting part, we have to understand what it's built on. Think of it like the raw  material for the entire financial system.

[00:07:52]And that raw material has a name, the money base.  So what exactly is the money base? Well, you can think of it as the total fundamental amount of  money that a central bank has put out there.

[00:08:03]It's really just two things. The physical cash you  might have in your pocket, plus the reserves that regular banks, you know, commercial banks, hold  at the central bank. It is the absolute bedrock of everything else we're about to talk about. Let's  actually put some numbers on this to make it real.

[00:08:18]Let's just imagine that our entire economy's money  base is a nice round 1,000. Now, of that 1,000, let's say 400 of it is physical cash floating  around in public and the other 600 is what the banks are holding as reserves. Got it? $400  and 600. Keep those numbers in your head cuz that's our starting point. Okay, so we've  got our money base of $1,000 all set up. Now, let's take a quick snapshot of the economy  before anything changes. But to do that, we need to introduce one more super important  rule that all the banks have to follow.

[00:08:50]And that rule is called the reserve ratio. This  is a big one. It's basically a regulation that the central bank sets. And it tells all the  other banks what fraction, what percentage of their customer deposits they absolutely must keep  on hand. They have to hold it in reserve. They're not allowed to lend this part out. It's a really  critical lever of control for the whole system.

[00:09:10]So, for our starting scenario, our little economy  here, let's just say the central bank has set this ratio at 25%. What does that actually mean? Well,  it means for every $100 that you or I deposit, the bank has to hold on to 25 of those dollars.  The other 75, they're free to lend that out.

[00:09:28]Okay? So, here's what the bank's books look like  at this point. We already know their reserves are 600, right? And because the rules say this  600 has to be 25% of all their deposits, we can actually work backward. It tells us  that the total deposits must be 2400. And if that's the case, it means the rest, the other  1,800, has been loaned out. See how that works?

[00:09:48]Assets and liabilities. Everything is perfectly  balanced. This is our stable before picture.

[00:09:54]Now, this is where we have to make a  really, really important distinction.

[00:09:58]The money supply is not the same thing as  the money base. The money supply is bigger.

[00:10:05]It's all that cash held by the public plus all  those checking account deposits sitting in the banking system. It's basically the money that's  ready and available for all of us to spend. So now we can finally figure out the total money supply  in our little economy. We just take that 400 in cash that's out there in people's hands and we  add the 2400 in bank deposits we just calculated and that gives us a starting money supply of  2,800. This is our baseline. Remember that number.

[00:10:33]All right, now for the action. Our nice, stable  economy is about to get a pretty big jolt.

[00:10:39]The central bank decides it's time to make one  single policy change. Just one little move that's going to trigger a powerful chain reaction through  the entire financial system. And what's their big move? It's actually pretty simple. They're going  to lower the reserve ratio. The central bank just decides that banks don't need to hold as much  cash anymore for every dollar that gets deposited.

[00:11:01]And this one little administrative change, well,  it's about to unleash a huge wave of new money.

[00:11:06]Let's just see how big of a change this is. The  ratio drops from 25% all the way down to just 10%.

[00:11:15]Think about that. Now, banks only have to hold on  to $10 for every hundred deposited. That frees up a ton more money to be lent out into the economy.  Okay, now listen closely because this is the most important and maybe the most counterintuitive part  of this whole thing. Even though the rules just changed, the actual money base, that bedrock we  talked about has not changed. Not one bit. There is still only 400 in cash out there and still only  600 in bank reserves. That amount is fixed. If you get this one point, the rest all clicks into  place. Okay. So, with that key rule in our minds that the money base is constant, we can now just  sit back and watch the dominoes fall. Let's trace exactly how this one simple rule change causes the  bank's balance sheets to just expand like crazy.

[00:12:04]And you know what? The math here is actually  surprisingly simple. We start with our bank reserves, which we know haven't changed. They're  still 600. But now that 600 only represents 10% of total deposits. So, what do we do? We divide  that 600 by the new ratio, 0.1. And boom, suddenly the total deposits supported by those exact same  reserves just ballooned to 6,000. And here it is, the brand new balance sheet. Just look at that  thing. The reserves, they're still 600. That didn't change, but now they're backing up 6,000  in deposits. And to make it all balance out, the banks have now been able to create a massive  5,400 in brand new loans. All because one little rule changed. All right, we've seen the mechanics.  We've watched the balance sheet explode. And now it is time for the big reveal. Let's calculate the  new total money supply in our transformed economy.

[00:13:02]So, what's our new grand total? We use the exact  same formula as before. We take the new deposit amount, which is 6,000, and we add that 400  in cash that's been there the whole time. The new money supply is 6,400. And here it is. This is  the real aha moment. Just look at this comparison.

[00:13:22]We started with a money supply of 2,800. And after  the central bank did nothing more than change a rule on a piece of paper, the money supply has now  exploded to 6,400. The amount of spendable money in the economy just more than doubled. And that's  the bottom line right there. A total of 3,600 in new money was just created and not by printing  a single bill, but just by changing the rules of lending. This new money exists as digital deposits  and loans created by the banking system itself.

[00:13:51]So what are the big takeaways here? What  should you really remember from all this?

[00:13:55]Well, first, the money base and the money  supply are two totally different beasts.

[00:14:00]Second, commercial banks really truly  do create money, not by printing it, but through the simple act of lending. And  finally, a central bank has this incredible power to expand the money supply just by  tweaking that little number, the reserve regime.

[00:14:14]Of course, this leaves us with a pretty huge  question, doesn't it? If banks can create money just like this, what's to stop them from creating  an infinite amount and causing total chaos?

[00:14:24]Well, the answer to that involves things  like central bank controls, economic demand, and the everpresent risk of bank runs. But that,  my friends, is a story for a whole other day.