The recent turmoil in the financial markets has raised the prospects of central bank intervention – especially in the United States given the dislocations in the Treasury market (Barrons, 2025). Against this backdrop it may be useful to provide a refresher on how the monetary system actually works and how does a central bank intervention occur in practice. I explain this by focusing on three misconceptions about the monetary system that I often come across. Let us start with the basics:

Misconception 1: A commercial bank lends out bank deposits

Most of the money is in the form of bank deposits. A widely held but incorrect belief is that banks operate as simple intermediaries, taking in deposits from savers and then lending them out to borrowers. But in reality, commercial banks do not lend out existing deposits; rather, they create new deposits when they extend loans.

What does this mean in practice? Well, when a bank approves a loan, it does not transfer money from another depositor's account to the borrower. Instead, after favourably evaluating a loan request, a bank official simply presses a button on a computer and creates new deposits for the borrower from thin air. Similarly, when this loan is eventually paid back, the money is destroyed—it disappears from the monetary system as easily as it was created.

If banks have the ability to create money and earn interest, why do they not create unlimited money and accumulate infinite wealth? In practice, the bank's ability—and willingness—to create money is constrained by capital requirements, regulatory constraints, and the borrower’s creditworthiness.

Figure 1 shows a simple example of money being created. A borrower applies for and is granted a loan of 100,000 euros. The bank creates a loan receivable on its asset side and new deposits in the borrower’s deposit account worth 100,000 euros on its liabilities side. The borrower’s balance sheet is simply a mirror image of that of the bank.

An obvious, although important, consequence of a bank’s money creation is its impact on the size of the banking sector. In a fictional world where banks are “pure intermediaries” and simply lend whatever money they receive from depositors, the size of the banking sector would not expand when banks issued new loans, and the money supply would be fixed. Instead, in the real world, where banks are money creators, they might sometimes create too much money, leading to excessive lending, a risk of a credit bubble, and even a financial crisis. At other times, they may lend too little, leading to stagnant economic activity or even recession.

Misconception 2: Central banks control the money supply

Another common misconception I hear is that the central bank directly controls the money supply. While it is true that central banks influence the money supply through monetary policy tools, they do not exert direct control over it.

As the above example shows, commercial banks are the primary money creators, not central banks, so the money supply is mostly determined by the interaction between commercial banks, businesses, and households. The central bank can influence short-term interest rates, conduct open market operations, and set reserve requirements, all of which loosen or restrict commercial banks’ ability and willingness to create money. However, central banks cannot dictate the volume of money created through lending decisions. For example, if commercial banks are unwilling to lend due to economic uncertainty, even ultra-low interest rates will not necessarily lead to an expansion of credit and money supply.

Due to these obstacles, in the last decade or so, many central banks engaged in a particularly aggressive type of open market operations, commonly referred to as quantitative easing.

Misconception 3: When central banks conduct Quantitative Easing, they "print money"

Quantitative easing (QE) is one of the central bank’s monetary policy tools, through which it attempts to impact the money supply. A particularly misleading phrase often used in media discussions is that central banks "print money" when engaging in QE. This gives the impression that new physical cash is being distributed freely into the economy, potentially leading to runaway inflation. However, this is not how QE actually works.

Quantitative easing involves the central bank purchasing financial assets, typically government bonds, from commercial banks and other financial institutions. In exchange, the central bank credits the transacting banks with additional reserves. These reserves are called “central bank money” since they are only used by commercial banks to trade with the central bank and with each other. While commercial banks hold these reserves as deposits at the central bank, reserves are not equivalent to money or deposits that nonbank entities like households or businesses can spend.

More specifically, QE works in two ways, depending on who the counterparty of the transaction is:

Case 1: QE when the counterparty is a commercial bank

When the central bank buys bonds (say, worth 100,000 euros) and the counterparty is a commercial bank, this can be seen as an asset swap for the bank, where it simply replaces the bonds it holds with central bank reserves. Just as a commercial bank creates deposits when extending a loan, the central bank creates reserves when buying financial assets. In this example, the commercial bank’s asset size remains unchanged, and no new bank deposits enter the financial system.

Case 2: QE when the counterparty is a nonbank investor

When the central bank buys bonds and the counterparty is not a commercial bank but instead a nonbank entity—e.g., a household or an institutional investor—this transaction does increase the bank’s asset size and creates deposits. The reason is that nonbanks do not have a reserve account at the central bank, so the commercial bank of this nonbank investor has to intermediate the transaction. Again, the central bank creates reserves that increase the commercial bank’s reserve holdings, and likewise, the commercial bank credits the seller (the nonbank entity) by creating new deposits that reflect the payment for the bond purchase.

As the example illustrates, QE simply reshuffles the ownership of different types of assets in the financial system. In practice, with QE, the central bank seeks to reduce the supply of long-maturity assets and replace those assets with short-maturity assets like reserves. This transaction aims to increase asset values, flatten the yield curve, and increase the availability of money or money-like assets for the private sector, which hopefully stimulates the real economy. Interestingly, in a theoretical frictionless world, this type of asset reshuffling should not impact asset prices. Thus, some of the empirical evidence suggesting the opposite has surprised some observers. In fact Ben Bernanke, former chairman of the Federal Reserve, has famously said, “The problem with QE is that it works in practice, but it does not work in theory” (Bernanke, 2022).

Conclusion

While the mechanisms outlined above are well understood by many students of central banks and the financial system, the misconceptions are still quite common, especially among the broader audience. At the time of the writing, the financial markets are in a high-volatility regime, and the US Treasury yields remain elevated but the Federal Reserve has not yet intervened. If this happens hopefully this article can give you some guidance about what this means in practice and how these central bank interventions might work.

Paul Rintamäki is a Doctoral Researcher and former Editor-in-Chief of AFA Quarterly.

References

Barrons - The Treasury Market Is Sending Alarms. Here’s How the Fed Could Help.
https://www.barrons.com/articles/treasury-market-yields-alarm-federal-reserve-intervention-7d9979ab
Acharya, V. V., & Rajan, R. (2024). Liquidity, liquidity everywhere, not a drop to use: Why flooding banks with central bank reserves may not expand liquidity. The Journal of Finance, 79(5), 2943-2991.
Bernanke, B. S. (2022). 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19. WW Norton & Company.

Debunking Monetary Myths: How Banks and Central Banks Operate

Greetings from Aalto Finance

AFA Quarterly in 2025 and going forward