Where Does Money Actually Come From?

Most people think they know where money comes from. The reality might surprise you.

Ask someone where money comes from, and they’ll probably say the government prints it, or that banks lend out money deposited by their customers.

Both sound perfectly reasonable.

But neither explains how most money is actually created in the modern economy.

And here’s the interesting bit: the Bank of England openly explains how it works.

Most money isn’t printed. It’s created by banks.

When we think of money, we tend to picture banknotes and coins.

But most money in the UK doesn’t exist as physical cash. It’s simply numbers in bank accounts.

And much of that money is created by commercial banks, such as Barclays, Lloyds and HSBC, when they make loans.

Yes, you read that correctly.

Banks create new money when they lend.

They don’t simply take £10,000 from somebody’s savings account and hand it to somebody else.

Let’s look at how it actually works.

Imagine you borrow £10,000 from your bank.

You walk into your bank and apply for a £10,000 loan.

The bank checks your income, credit history and ability to repay. Everything looks fine, so it approves your application.

Now here’s where things get interesting.

The bank doesn’t need to find another customer who’s deposited £10,000 before it can make your loan.

Instead, it credits your account with £10,000.

Your balance increases by £10,000, and you now owe the bank £10,000.

That £10,000 deposit is newly created money.

Before the loan was approved, it didn’t exist as money in your account. Now it does.

And you can spend it just like any other money.

This isn’t some alternative economic theory. It’s how the Bank of England itself describes modern banking.

So banks can just create unlimited money?

No. And this is an important distinction.

Banks can’t simply create as much money as they fancy.

They face several restrictions, including:

Capital requirements: Banks must have sufficient financial resources to absorb potential losses.
Creditworthiness: Lending to people who cannot repay is a good way to lose money.
Interest rates: Higher borrowing costs generally discourage people and businesses from taking out loans.
Liquidity: Banks need access to the money used to settle payments with other banks.

So although banks create money through lending, they certainly don’t have a free pass to create unlimited amounts.

Here’s another surprise: repaying loans destroys money.

Remember that £10,000 loan?

When you repay the principal, the process works in reverse.

The money used to repay the loan is removed from the stock of bank deposits.

In simple terms:

Banks create money when they lend, and destroy money when loans are repaid.

The interest you pay is different. That’s income for the bank, not money destroyed in the same way.

This means money is constantly being created and destroyed throughout the economy.

Every day.

What about the Bank of England?

The Bank of England also creates money, but it’s a different kind.

It issues banknotes and creates electronic money known as central bank reserves.

These reserves are mainly used by commercial banks to settle payments between themselves.

For example, if you transfer £1,000 from Barclays to someone at Lloyds, the banks can settle the payment using their accounts at the Bank of England.

The Bank of England also influences how much money commercial banks create, particularly through interest rates.

But it doesn’t normally decide exactly how much each bank can lend.

Why does any of this matter?

Because once you understand where money comes from, you start looking at the economy differently.

Think about it.

If banks create much of our money through lending, then borrowing isn’t simply moving existing money around.

New lending can increase the amount of money circulating in the economy.

And when debts are repaid without being replaced by new lending, that can reduce it.

That has important consequences for spending, house prices, business investment and economic growth.

It also raises an interesting question.

If banks have such an important role in creating money, shouldn’t more people understand how the system actually works?

I’d argue they absolutely should.

The bottom line

Most money in the UK isn’t created by printing banknotes.

It’s created electronically, largely when commercial banks issue loans.

And when those loans are repaid, that money is destroyed.

That’s the basic principle.

No complicated equations. No economics degree required.

Just an understanding of something that affects virtually every aspect of our lives, yet is surprisingly rarely explained properly.

And if that surprised you, there’s plenty more to discover about how our economy really works.