Money creation is a process for making the money supply in a country larger. There are a number of ways to increase the money supply, and growing the supply over time is a key economic function, making funds available for when people need them. Regulatory agencies responsible for setting and enacting monetary policy can engage in money creation and so can banks, while they go about their daily business and regular financial activities.
Printing money to increase the currency supply is one option for making more money available, but money creation involves some different approaches. One option is for monetary policymakers to acquire assets, exchanging money for them and increasing the supply of available money by getting more money into circulation. Exchanging money for something of value allows the money supply to grow in a stable and controlled fashion.
Another option is through the fractional reserve banking system used in most nations. When people deposit money in a bank, the bank is required to keep a percentage of the deposit on hand. It can take the rest of the money and use it for investments and loans. This results in money creation, as the original amount of the deposit still exists and is counted in the assets and liabilities of the bank. In a simple example, if someone deposits 100 units of currency in a bank working in a country with a 3% reserve requirement, the bank must keep three units on hand, and it has 97 to loan or otherwise use, effectively turning the 100 unit deposit into 197 units.
Banks engage in money creation every time they make loans and investments, and they earn money in the process by charging or receiving interest. This causes a steady growth in the size of the economy, as every time people bank, they contribute to money creation. The money loaned by the bank will come back in with another deposit, with the bank placing some funds in reserve and lending the rest out, and so forth. The amount of money in circulation actually exceeds the total of available currency, as often money moves in the form of numbers from account to account, without actually being physically present.
Checks on money creation are designed to prevent problems like inflation. The money supply can be decreased by changing interest rates, making credit less available and restricting the numbers of loans banks can offer. Currency can also be recalled to affect the currency supply, and reserve requirements may be adjusted to make banks keep more money on hand.
