Most money is created by private banks when they lend money. It is created from nothing by the very process of lending it in the money creation cycle, on the basis of your promise to repay the money in the future.

The test of the process of creating money through debt comes when you spend the money that you have borrowed; it would seem that the bank has nothing to hand out when you buy things with that money other than your promise to repay the loan. If, for instance, you were to buy a car with the money in your account how can the bank give the money to the seller of the car when they have effectively typed a balance into your account?

If everyone took the money that they have borrowed from the bank to spend as true cash (bank notes and coins) there would indeed be a problem, but almost no one does; most money changes hands as electronic fund transfers.  Before electronic banking came into use people used cheques (paper fund transfers) to transfer money. These transfers remove the need for the bank to actually come up with the money. When money is directly transferred between loan or savings accounts by electronic and cheque transfers the balance of the various accounts are simply increased or reduced as required, as the imaginary "cash" is transferred between them; the process looks like this:

When Jack sells goods to Jane, and Jane pays using a transfer (direct deposit, cheque, EFTPOS, or credit card), the bank reduces the balance of her account by the price of the goods, $20, and increases the balance of Jack's account by the same amount, $20. Jane's account reduces from $100 to $80 and Jack's account increases from $100 to $120.

Notice that before the transaction the total of Jane and Jack's accounts in the bank is $200 and after the transaction the total of their accounts is still is $200, so the total amount of money in the bank doesn't change and no actual cash needs to be transferred anywhere.

If Jane's account is a loan account, then the money in it was created by the bank typing a balance into her account. That the money was created this way doesn't matter, because the transfer is just numbers changing in the accounts, and no physical money is required.

Most transactions won't involve the withdrawal of money from an account that is at the same bank as the subsequent re-deposit into another account, however the process works in the same way between different banks.

As long as money is moved around by means such as transfers and cheques it never needs to be converted to physical cash, so the fact that it is created from nothing doesn't cause a problem. These electronic and cheque transfers are money: a private equivalent to the bank notes and coins issued by governments, but created by the banks. About 95% of the money in circulation moves around this way, only about 5% is cash circulating as bank notes and coins.

You probably though of money as coins and bank notes that existed in some vast store within your bank, however this isn't so; almost all money exists only as numbers in accounts.

This process seems like a crazy juggling act, but realise that money is only an idea that enables the exchanges of products (goods and services); it is the exchanged goods and services that have the value, the money is an intermediary of no intrinsic value. The money moves invisibly between people who are buying and selling things to each other, and as long as they can complete their exchanges of goods and services this invisible and intangible money serves its purpose.

This page is linked from:

How money is created 

Transferring money between banks 

The money creation process

Bank reserves for cash withdrawals 

How reserves limit the creation of money

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