How monetary systems work

Most money people use is held in bank accounts. Commercial banks create deposits when they lend. The central bank issues cash and provides reserve accounts that banks use to settle payments with one another.

People can use these linked forms of money at the same stated value. Central banks influence borrowing costs and overall demand, but they do not directly control every loan, deposit, or price.

Three forms of money

Modern monetary systems generally have three connected forms of money:

• Cash: Notes and coins issued by a public authority.
• Bank deposits: Households and businesses use these account balances to make payments. A deposit is a liability of the bank that holds it.
• Central-bank reserves: Balances commercial banks hold at the central bank. Reserves are assets for those banks and liabilities of the central bank.

People use deposits for ordinary payments. Banks use reserves to settle many obligations with other banks. A household does not normally hold reserves at the Federal Reserve, just as a customer’s checking account balance is not itself a reserve balance.

Together, these roles form a two-tier system: central-bank money helps banks settle payments with one another, while commercial-bank deposits handle most day-to-day payments. The arrangement depends on confidence that deposits and cash will be accepted at their stated value.

Money also gives people a shared unit for setting prices and keeping accounts, and lets them save purchasing power for later. For example, you can save or spend a paycheck deposited into your account, and use money to compare the cost of a purchase.

How bank loans create deposits

When a commercial bank approves a loan, it typically creates a deposit by crediting the borrower’s account. The bank records the loan as an asset because the borrower owes the money, and the new deposit as a liability because the bank owes that balance to the customer.

For example, a $100 loan gives the borrower a $100 deposit and a $100 debt. The borrower has more money available to spend, but also owes the bank $100. The transaction creates money in the form of a deposit; by itself, it does not create wealth.

When a borrower repays loan principal, the bank reduces the loan balance and removes the corresponding deposit money. By contrast, when the borrower spends the deposit, the money generally moves to the seller’s account rather than disappearing.

Banks cannot create deposits without limit. They need borrowers who qualify for loans and lending that can earn a return after costs and risks. They also need capital to absorb losses, liquid funds to meet withdrawals and payments, reliable funding, and a way to meet their payment obligations. They must also follow applicable rules.

This is why the common picture of banks simply lending out a fixed pool of customer savings is incomplete. A simplified “money multiplier” model, in which banks mechanically turn reserves into a larger amount of loans, also does not describe ordinary modern lending step by step. Lending decisions depend on borrower demand, expected returns, risk, and banks’ constraints.

How banks settle payments

When a customer at Bank A pays someone who uses Bank B, the banks update the customers’ deposit balances. Bank A now owes money to Bank B, so the banks settle that obligation, usually with balances held at the central bank.

Large-value U.S. payments can move through Fedwire Funds Service, a Federal Reserve service that settles transfers in real time. Transfers completed through Fedwire are final and irrevocable. Many everyday card and electronic payments use other arrangements, so Fedwire is an example of settlement infrastructure rather than the route for every purchase.

Reserves help banks complete these interbank payments and manage liquidity. They are part of the machinery behind payments, even though customers normally pay with deposits.

How central banks influence money

Central banks steer financial conditions mainly by influencing interest rates and the availability of central-bank money. In the United States, the Federal Reserve uses a target range for the federal funds rate, the rate banks charge one another for overnight loans of reserve balances. Interest paid on reserve balances is one tool the Fed uses to put pressure on short-term rates.

Changes in short-term rates affect other borrowing costs and financial conditions. Those changes influence household decisions about buying on credit. They also affect whether businesses invest and whether borrowers refinance. Shifts in spending and demand can then affect employment and inflation. The effects take time and are not mechanically predictable.

The Federal Reserve’s mandate includes maximum employment and stable prices. It judges an annual inflation rate of 2%, measured by the personal consumption expenditures price index, to be consistent with those goals over time.

Monetary arrangements vary by country. A central bank that keeps its currency at a set value against another currency has less room to set interest rates independently than one whose currency’s value moves with the market. The exact tools, mandates, and payment arrangements also differ.

Why reserves do not dictate lending

The central bank creates reserve balances. Commercial banks create customer deposits through lending. These two forms of money are related, but a change in reserves does not automatically produce a proportional change in loans or deposits.

For example, when the Federal Reserve buys a Treasury security from a bank, the bank swaps one asset for another: it holds more reserves and fewer securities. That purchase does not itself create a customer deposit. When the Fed buys a security from a nonbank seller, the seller can receive a new bank deposit while the seller’s bank receives reserves.

Government payments also affect deposits. During the period from the fourth quarter of 2019 to the fourth quarter of 2021, U.S. household fiscal transfers were one factor behind deposit growth. Credit-line drawdowns and Federal Reserve asset purchases also contributed, as did a higher saving rate. This episode does not establish a permanent relationship between government payments and deposit growth.

What M1 and M2 measure

Statistical measures such as M1 and M2 group different kinds of money and assets that can be turned into spendable money relatively easily. In the United States, M1 includes currency and deposits people can use directly for payments. M2 includes M1 along with certain less-liquid savings assets.

These measures are useful for tracking broad changes, but they are not interchangeable with the monetary base, which consists of currency in circulation plus bank reserve balances. Definitions also vary across countries and can change over time. The Federal Reserve changed the composition of U.S. M1 in May 2020, so comparisons across that date need care.

Money growth can provide information about economic conditions, but it does not by itself explain inflation. A 2023 study by the Bank for International Settlements found that money growth’s relationship with inflation varied across periods: it was stronger when inflation was high and weaker when inflation was low. The study also found that money growth came before the post-pandemic rise in inflation across the countries it studied. That timing alone does not prove that money growth caused the price increases.

Central banks therefore consider money measures alongside interest rates, spending, employment, prices, and other information. No single measure offers a complete account of inflation or a reliable rule for predicting it in every situation.