Cash, which includes banknotes and coins in circulation, together with bank reserves (i.e. commercial banks’ deposits with the central bank), make up the monetary base. This monetary base can only be expanded by central banks – in the case of the euro area, the European Central Bank (ECB) and national central banks –, either by printing banknotes and minting coins, or by creating bank reserves, which are an electronic form of money.
Central banks’ balance sheets are divided into assets and liabilities (see the ECB’s annual consolidated balance sheet
). When it creates money, the Eurosystem increases the liability side of its balance sheet, which is balanced by an equal increase on the asset side. The Eurosystem may expand its balance sheet in response to a greater liquidity demand by commercial banks or to the ECB’s explicit desire to increase its balance sheet by a predetermined amount. In the latter case, the ECB can purchase financial assets, such as government or corporate bonds. It can also provide a predetermined amount of financing to banks. The financial assets obtained by the ECB will be recorded in the asset side of its balance sheet.
The ECB does not actually print new banknotes to purchase these assets, but rather creates money electronically in the form of bank reserves. For example, in refinancing operations with commercial banks, the central bank credits the amount granted to the participating banks directly into their current account with the central bank. Financial asset purchases also cause reserves to rise, either because the seller is a commercial bank or an agent that has a current account with a commercial bank. In the latter case, the central bank credits the amount of the sale to the commercial bank so that it can, in turn, pay the seller.
However, the monetary base only accounts for a small share of total money in circulation. Most of the money we use is created by commercial banks when they lend money. When a commercial bank issues a new loan to its customers and credits their current accounts with the corresponding amount, it is creating "inside money". This money will be used to buy goods or make investments and will eventually end up being deposited in other bank accounts. Conversely, when customers pay off their debts, that inside money is destroyed.
To ensure that this process does not repeat itself endlessly and that the money in circulation does not exceed the desired amount (which would have an adverse impact on price stability and lead to inflation), the process of creating money is controlled and regulated by central banks and other supervisory authorities. Central banks set minimum reserve requirements, which commercial banks must satisfy with cash holdings at the central bank. Minimum reserve requirements establish a minimum liquidity ratio (as a percentage of a bank’s customer deposits), meaning the minimum percentage of liquid assets that must be held at the central bank, thus limiting the amount of money that commercial banks can lend and, therefore, create. A number of additional regulations on banks’ capital and solvency also limit the creation of inside money.