The idea that banks create money from nothing by the process of lending it is very hard to accept. Here is a practical description of how it may be done.

Most banks offer a loan with redraw. When you take out such a loan it is given to you in the form of a bank account from which you can withdraw and repay money freely as long as you keep the balance above the minimum.  The required minimum balance continually increases over the life of the loan until it is paid off.

Imaging that you take out such a loan: you provide a written promise to the bank (the loan contract) that you will repay whatever you withdraw from the loan, plus the interest, and the bank promises to make the money you have borrowed (the principal) available to you.

When the bank creates this loan it gives it to you in the form of an account with an available, drawable balance, so that you can withdraw the money when you are ready. A loan account, with an available balance of $10,000, can be represented like this:

The loan account is shown below the zero dollars line because when you take money from it you will go into debt.  The grey fill represents the available, but as yet unused, balance.

At this stage you haven't withdrawn anything from the loan, so, even though the bank has given you an account with an available balance, you haven't yet actually borrowed any money, and the amount of money that the bank holds hasn't changed. Because you haven't borrowed any money yet, the bank won't be charging you any interest.

Now imagine that you open a savings account at the same bank. The saving account can be represented, alongside the loan account, like this:

The savings account is shown above the zero dollars line because when you put money into it you will go into credit.  The grey fill represents the empty savings account. 

At this stage the savings account is empty, and you still haven't withdrawn anything from the loan account, so you still haven't borrowed any money, and the amount of money that the bank holds still hasn't changed.

Now you transfer some money from your loan account to your savings account. The transfer and the two accounts now look like this:

The red fill in the loan account represents the money that you have withdrawn from it; the green fill in the savings account represents the money that you have deposited into it.

This is the action that creates the money: that deposit into your savings account (the green fill) means that you now have actual money in it.  When money is created this way an equal value of debt (in the loan account) is created along with it.

Notice that the total amount of money the bank holds still hasn't changed, because no money has actually left or come into the bank; only the numbers in the accounts have changed.  The credit in the savings account has increased and the debt in the loan account has increased by the same amount, canceling each out. As no money has needed to come into the bank to make the money in the savings account available, it has been created from nothing: out of thin air! 

You may feel that the balance in the savings account isn't real money; however, it is as real as any money that you may have in your real saving account now.  In fact, its existence is identical to the existence of money in your real saving account. Even though the money in the savings account and the debt in the loan account exist only as numbers in those accounts (it's called account entry money) it's real money.

But, won't the bank have to actually get money from somewhere when you want to withdraw money from the savings account?

This page is referenced from:

How money is created 

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