Update Dec 2015. This version does not reflect the way modern banks work. A new version is posted here.
[Update 18 March 2010: this is the text-book explanation, but Steve Keen argues persuasively that this is only a minor part of the modern money creation process, most of which is beyond the control of central banks. See Kevin Cox’s comment below, including his proposed remedy.]
A little-known or poorly understood fact about our banking system is that banks create money. Out of nothing.
That in itself need not be a bad thing. We need a medium of exchange, which is the basic function of money, and the money has to come from somewhere. However the creation of new money is buried within our fractional-reserve system of banking. This makes it invisible to most people. Also, banks create the money in the course of making loans, which means they can charge interest on money they create at essentially no cost to themselves. That is a guarantee of unearned profits, even apart from the myriad fees banks charge for other services.
Because the fact and the process are obscure, I post here an explanation of how it comes about.
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