How do banks create money?

Banks create money primarily through the process of fractional reserve banking. In this system, banks are required to maintain a fraction of their deposits as reserves while being allowed to lend out the remainder. When a bank receives a deposit, it only holds a fraction of that deposit in reserve (as cash or in a reserve account at the central bank) and can use the excess funds to issue loans or create new deposits.

This process effectively creates new money in the economy. For example, if someone deposits $1,000 in a bank and the reserve requirement is set at 10%, the bank would hold $100 in reserves and could lend out $900. When that $900 is spent and deposited in another bank, that bank can also lend out a portion of that amount, thereby multiplying the money supply further. This mechanism illustrates how banks can expand the overall amount of money in circulation through lending practices.

In contrast, issuing stock or selling government bonds does not directly create new money; instead, it involves transactions that may influence bank operations or the overall economy but does not inherently increase the money supply like lending does. Converting foreign currencies involves exchange activities rather than the creation of money in the banking system. Therefore, fractional reserve banking is the clear answer, as it