Money Is Created Out Of Thin Air | The Reason Why

We grew up believing a story that banks collect money from people like us, keep that money safe, and then lend some of it to others. The functions are right, but the sequence is not.

Deposits don’t create money; the lending does. Once you get this, a lot of the economic world suddenly stops becoming mysterious.

Broadly, there are two kinds of money. The first is central bank money. This is cash in your wallet, and the reserves commercial banks hold with the RBI. But RBI creates money in more interesting ways, too. Whenever the RBI buys dollars and government securities, it creates new central bank money.

The second type is commercial bank money — the balance you see in your app, the deposits. RBI doesn’t print that.  Banks create it when they give loans. Most of the money we spend every day — UPI transactions, salaries, EMIs, shopping — is actually this bank-created money.

And just to be clear: both central bank money and commercial bank money are fully valid Indian rupees. For practical, day-to-day use, this distinction doesn’t matter.

Now, let’s understand in detail how the banks create it. Take a housing loan of Rs. 50 lakh. The bank doesn’t deduct someone else’s account balance and give it to you. It doesn’t even remove the cash in its vault. Here’s what happens:

-        The officer approves the loan, types in your details,

-        Creates a loan account on its books — you owe the bank Rs. 50 lakh – so it becomes an asset for the bank

-        Creates a matching deposit or a liability — the bank owes Rs. 50 lakh to you or the seller.

-        That liability can be shown either by directly transferring the money into your savings account or into the builder’s or seller’s account.

Either way, the bank’s balance sheet grows on both sides (assets and liabilities). That expansion is the new money created through accounting entries without touching the printing press or the vault. Therefore, it is said that banks can create money out of thin air.

Most of us feel that money gets created when we deposit it in the bank or when we get a salary. But these are just transfers. When you receive a salary, your bank balance increases, but the company’s balance falls.

Then, when you spend on a new t-shirt, your balance goes down, while the apparel company’s balance rises. It’s all transfers. No new money has entered the system.

Last year, I remember, there was a lot of chatter about how stock-market investing has impacted banks. Some said that deposits are not growing fast because people have moved from fixed deposits to stock markets and mutual funds. That’s not a correct connection.

When you buy a share, money moves from the buyer’s account to the seller’s account. When you transfer money to a broker, it is transferred to a client’s escrow account maintained with its bank.

All money – whether invested in shares, mutual funds, or fixed deposits - stays inside the banking system. The amount of total deposits doesn’t change.

Therefore, it’s not right to say that total deposit growth has slowed because people are investing elsewhere. Deposit growth slows only when credit creation slows.

But this superpower of creating money out of thin air has some limitations. They cannot create it indefinitely, even if they want to. Firstly, banks must stay profitable, and aggressive lending cuts into profits. Due to aggressive lending post the 2008 financial crisis, Indian banks saw a steep rise in their non-performing assets. They turned cautious after this episode.

Secondly, even though banks are willing to lend, they must find willing borrowers, too. Currently, India’s credit growth has slowed to 12% YoY from the highs of 17-20% couple of years ago. According to a Financial Express report, corporate India is not borrowing much as they are sitting on a cash pile of over Rs. 14 trillion, up by 11% from the last year.

And most importantly, the central bank controls the price of money through interest rates. Higher rates reduce borrowing, which slows money creation. So banks create money, but they cannot create it recklessly.

As banks have the power to create money, we have the power to destroy it. No. Not by throwing it away or putting it on fire. If loans create money, repayment destroys it. When you repay your EMI, the bank reduces your loan (its asset) as well as deposit (its liability) balances.

That portion of the money you borrowed is extinguished. The Financial Express report stated that instead of borrowing, companies are repaying their old loans. For instance, in FY25, more than 300 companies have turned debt-free.

Similarly, when the RBI sells dollars or government securities, it pulls money out of the system, and the central bank money which it might have created earlier, is destroyed. When the RBI tried to manage exchange rate volatility in the last few months, it sold dollars from the reserves. Creation and destruction of money is an ongoing process in the modern economy.

Most of us grew up with the wrong picture: deposits first, loans later. But it’s the opposite: loans come first, deposits follow. If we understand money, we understand everything that depends on it — banking, debt, taxes, inflation, monetary policy, cryptocurrencies, and even the role of government.

 And this is just the beginning — the real fun starts when you look at the limits of money creation, how crises flip the system, why cryptocurrencies were born, and how the very idea of “money” keeps changing. More on these topics soon.

The views expressed in this article are solely those of the author and do not necessarily reflect the opinion of NDTV Profit or its affiliates. Readers are advised to conduct their own research or consult a qualified professional before making any investment or business decisions. NDTV Profit does not guarantee the accuracy, completeness, or reliability of the information presented in this article.