When you deposit $1,000 in your bank, you probably imagine it sitting in a vault somewhere, waiting for you to withdraw it. Meanwhile, when your neighbor gets a loan, you might assume the bank is lending out someone else's deposits. This intuitive understanding of banking seems logical, but it's fundamentally wrong.

The reality is far more surprising: commercial banks don't lend out existing money – they create brand new money every time they make a loan. This isn't some conspiracy theory or economic fringe idea. It's how modern banking has worked for decades, yet most people have no idea their local bank branch is essentially a money-printing operation.

Here's what actually happens when you get a $10,000 car loan: the bank doesn't take $10,000 from its vault or from other customers' accounts. Instead, it simply types $10,000 into your account. That's it. The bank creates this money by simultaneously creating an asset (your promise to repay) and a liability (the deposit in your account). New money has just entered the economy.

This process works because we treat bank deposits as money. When the car dealer receives your $10,000 payment, they accept it as readily as cash because bank deposits are functionally identical to money in our economy. The dealer can use those deposits to pay employees, buy inventory, or anything else. Each new loan expands the total money supply circulating through the economy.

Think about the implications: if banks stopped lending tomorrow, the money supply would actually shrink as existing loans get repaid without new ones being created. During the 2008 financial crisis, this is exactly what happened – banks became afraid to lend, credit dried up, and the money supply contracted, deepening the recession. The health of the banking system directly determines how much money exists in the economy.

If banks can create money out of thin air, why don't they create infinite amounts? The answer lies in a web of constraints that keep the system in check. Traditionally, banks had to keep a certain percentage of deposits as reserves at the central bank – if they had $100 in deposits, they might need to keep $10 in reserves. This seemed to limit how much they could lend.

But here's where it gets interesting: many countries have eliminated reserve requirements entirely, yet banks haven't gone wild creating money. Why? Because reserves were never the real constraint. Banks face multiple limits: they need to find creditworthy borrowers, compete with other banks for profitable loans, maintain certain capital ratios to absorb losses, and meet regulatory requirements. Most importantly, every loan they make is a risk – if borrowers default, the bank loses real money.

The actual constraint is capital, not reserves. Banks must maintain a cushion of shareholder equity to absorb losses. If a bank has $10 million in capital, regulations might allow it to have $100 million in risk-weighted assets. This capital requirement, combined with the bank's appetite for risk and the availability of profitable lending opportunities, determines how much money it will create through lending.

Central banks like the Federal Reserve don't directly control how much money banks create, but they powerfully influence it through interest rates. When the Fed sets the federal funds rate, it's essentially setting the wholesale price of money. Banks borrow from each other and from the Fed at rates influenced by this benchmark, which affects the rates they charge customers.

When central banks lower rates, loans become cheaper, more people and businesses want to borrow, and banks create more money through increased lending. When rates rise, the opposite happens – loans become expensive, demand drops, and money creation slows. It's like controlling the flow of water not by turning the faucet, but by adjusting the water pressure in the entire system.

This indirect control can be frustratingly imprecise. During economic downturns, central banks might slash interest rates to zero, desperately trying to encourage lending and money creation. But if businesses are scared and consumers are saving, banks might still refuse to lend, creating what economists call a 'liquidity trap.' Japan experienced this for decades – ultra-low rates couldn't force banks to create money when nobody wanted to borrow. The central bank can lead banks to water, but it can't make them lend.

The next time you hear that the government is 'printing money,' remember that most money creation happens at your local bank branch, not at the Federal Reserve. Every mortgage, business loan, and credit card purchase involves a commercial bank creating new money that didn't exist moments before.

Understanding this transforms how you see economic news. When you hear about credit crunches, banking regulations, or interest rate changes, you're really hearing about the mechanisms that determine how much money exists in the economy. Banks aren't just intermediaries moving money around – they're the factories where most money is actually made.