Module 3 of 4
How Fiat Is Created
The mechanics of modern currency creation, in the specific detail most people never learn.
Film · Mostly by lending · 1:41
Block ———A short film for module 3 of Understanding Money: a bank loan drawn on a balance sheet, where the loan and a matching deposit appear at once and cancel when it is repaid; why 97% of UK money was bank deposits in 2013; how central banks create reserves, set their interest rate and buy bonds in quantitative easing; how far US broad money has grown since 1971; and how bitcoin's supply follows a fixed schedule instead, so that one bitcoin is always one bitcoin and no one can lend more of it into being. It loops while on screen; use Pause to stop it. Turn on Narration to hear it explained aloud. A transcript follows.
Read the film, with its sources
- Understanding Money · Module 3 of 4How Fiat Is Created. Who makes money? Most people would say the government, printing it. For most of the money in use, that is not how it happens.
- A new loanMost money is created by commercial banks, when they lend. When a bank makes a loan, it creates a matching deposit in the borrower’s account at the same moment: a £10,000 loan (an illustration) is a new £10,000 asset for the bank and a new £10,000 deposit for the borrower. No one else’s savings are lent out. In the Bank of England’s words, “bank lending creates deposits”.McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 14
- RepaidThe deposit is new money. When the loan is repaid, it works in reverse: the deposit is cancelled against the loan, and the money is destroyed. When banks lend more than is repaid, the money supply grows.McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 16
- DEC 2013So most money is not notes and coins. Of the broad money held in the UK in December 2013, 97% was bank deposits and 3% was notes and coins.McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 15, dec 2013
- Two kinds of moneyThe central bank creates a different kind of money: reserves, which only banks can hold, and which banks use to pay each other. In normal times it sets the interest rate paid on reserves, and that influences the rates banks charge on loans.McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 14
- Quantitative easingIn quantitative easing the central bank buys assets, mainly government bonds and mainly from firms such as pension funds, paying with reserves it has just created. The seller’s bank gets the new reserves; the seller is left holding a new deposit in place of the bond. The Federal Reserve’s balance sheet peaked at $8.97 trillion on 13 April 2022.McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 24Federal Reserve, H.4.1 via FRED (WALCL), 13 apr 2022
- AUG 1971 → AUG 2026No fixed limit caps the total. Banks are limited by profitability, by regulation and by the central bank’s policy, and the rules and the policy can change. M2, the US broad money supply, was $685.5 billion in August 1971 and $23.3 trillion in August 2026: 34 times as much.Federal Reserve, H.6, via FRED (M2SL), aug 1971Federal Reserve, H.6, 22 September 2026, aug 2026McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin 2014 Q1, p. 14
- BitcoinBitcoin works differently. No one lends it into being: new coins are issued on a fixed schedule, block by block, and there will never be more than 21 million. Anyone can check how many exist; the film shows the count at the latest block.The Bitcoin Transition, the 21 million schedule (computed from the issuance rules)
- One bitcoinMeasured in fiat, bitcoin’s price moves. But one bitcoin is always one bitcoin, and no one can lend more of it into being. Few goods are priced in it yet, so for most people it is not yet a unit of account, and keeping it safely takes care.
- The Bitcoin TransitionHow is fiat created? Mostly by lending. Bitcoin: by rule.
Most people assume that currency is printed by the government and distributed as wages or benefits. This is not how the modern fiat system works. Almost all new money in circulation is created by commercial banks, through the process of issuing loans. The central bank plays a supporting role by setting the price of reserves and by purchasing government bonds.
Commercial Bank Money Creation
When a bank issues a loan, it does not transfer money from some other depositor's account. It creates a new deposit in the borrower's account, marking the loan as an asset on its own balance sheet. The accounting entries are symmetric: a new liability (the deposit) and a new asset (the loan).
This process creates new money from nothing. It is limited only by the bank's capital ratios, regulatory rules, and the willingness of borrowers to take on debt. When the loan is eventually repaid, the money is destroyed — the deposit is cancelled against the loan. The system grows or shrinks depending on the net rate of new borrowing versus repayment.
Central Bank Operations
The central bank does not create most of the money in circulation. It creates reserves — a special kind of bank liability used only between banks. These reserves back the commercial banks' liabilities and are the ultimate settlement asset in the domestic payment system.
When the central bank wants to increase the money supply, it buys assets (typically government bonds) from commercial banks, crediting their reserve accounts. This gives the commercial banks more capacity to issue new loans — which is how the newly created reserves translate into new money in the wider economy.
This is what quantitative easing is, in technical terms. The central bank expands its balance sheet by buying assets, the commercial banks receive new reserves, and the resulting capacity for new lending eventually propagates into the prices of everything else. The lag between central bank action and consumer price response is typically twelve to eighteen months.
Why the Supply Is Unbounded
There is no hard upper limit on how much new money can be created. The central bank can buy any quantity of eligible assets. Commercial banks can issue any volume of loans subject to capital constraints, which are themselves set by regulation and can be changed.
This is the structural feature that distinguishes fiat from hard money. There is no external constraint on supply. Every other monetary good in history had some physical limit — gold had mining, silver had mining, stones had quarrying, shells had reef growth. Fiat has no such limit. The supply is governed by political and institutional decisions.
The Consequence
Over decades, the trend in every fiat system has been toward more aggressive expansion. This is not because central bankers are dishonest. It is because the incentives of the political system reward expansion: expansion finances deficits, lowers interest payments on existing debt, suppresses the cost of financing, and distributes benefits to the politically connected first recipients of new money (see the Cantillon effect).
Contraction, by contrast, is politically costly. Reducing the money supply means allowing malinvestments to liquidate, asset prices to fall, and debt burdens to become harder to service. No elected government has strong incentives to allow this to happen on its watch. The system therefore expands, always, in the long run.
This is the structural argument for hard money. Not that central bankers are bad actors, but that the institutions they operate cannot, by their nature, maintain purchasing power over time. Bitcoin removes the problem by removing the discretion.