How Money Actually Works: Step-by-Step

In a nutshell

Most people think money is some natural thing that exists independently, but it’s actually a government creation. Once you accept this basic fact, everything else about how the economy works becomes completely logical and predictable. The government creates money, demands you pay taxes in that money, and therefore must spend money into existence before it can collect it back. This creates a chain of logical necessities that explains unemployment, inflation, government debt, and even how banks work, all following inevitably from that first simple truth about what money actually is.

The full explanation

Understanding money requires following a logical chain where each step makes the next one inevitable. Skip any step and the whole system stops making sense.

Step 1: Money is a Government Monopoly - Only the UK government can legally create pounds sterling. Private individuals can’t print pound notes or create electronic money in your bank account. Only state sanctioned institutions can do that. This isn’t controversial; it’s simply how the law works. The government decides what counts as official money and enforces this through its legal system.
Step 2: Taxes Create Money Demand - Since only the government creates pounds, and the government demands you pay taxes in pounds, everyone needs to get pounds from the government somehow. You can’t pay your taxes with anything else, not euros, not gold, not Bitcoin, not private IOUs. This legal requirement creates universal demand for the government’s currency among everyone who might owe taxes.
Step 3: Government Must Spend First - Here’s where logic becomes inescapable: if you need government money to pay taxes, but only the government can create that money, then the government must spend money into existence before anyone can pay taxes with it. You can’t pay taxes with money that doesn’t exist yet. The sequence must be: government spending → people have money → people pay taxes.
Step 4: The Employment Guarantee Logic - If the government demands tax payments, it’s logically obligated to provide ways for people to earn the money to pay those taxes. Widespread unemployment means the government isn’t spending enough money into the economy for people to meet their tax obligations. The government must offer to buy people’s labour and goods at prices that allow tax payments to be made.
Step 5: Government Spending Sets All Prices - Whatever the government pays for labor becomes the baseline price for all work in the economy. If the government offers jobs at £15/hour, private employers must offer at least that much to attract workers. This means government spending decisions don’t just affect government workers, they anchor the entire price system throughout the economy.
Step 6: Real Resources, Not Money, Constrain Spending - Since the government creates money by typing numbers into computers, it can never “run out” of money. The real limit is running out of things to buy: workers, materials, energy, land. When government spending tries to buy more than the economy can produce by raising its prices, you get inflation as people bid against each other for limited resources.

Frequently Asked Questions (FAQ)

This seems too simple. Surely the economy is more complicated than this? The basic logic is indeed simple, but its implications are profound. Complex financial instruments and market fluctuations all operate on top of this fundamental structure. Understanding the foundation doesn’t mean ignoring complexity, it means seeing how that complexity connects to underlying realities.
What about banks? Don’t they create money too? Banks create money when they make loans, but they’re operating under government license. Bank money is only valuable because it’s convertible to government money on demand. Banks are essentially franchisees of the government’s money system, not independent money creators.
If this logic is so obvious, why don’t economists and politicians understand it? Many do understand it operationally but describe it differently for political reasons. Central bankers routinely create money knowing the government can always pay them back. The confusion comes from using household budget analogies that don’t apply to currency issuers.
Doesn’t this mean the government can just spend unlimited amounts on anything? No, the constraint is real resources, not money. If the government tries to hire all the nurses when hospitals are already fully staffed, it will just bid up wages without getting more healthcare. The government must consider whether real resources are available.
What about other countries’ currencies? Does this logic apply everywhere? This logic applies to any country that issues its own currency and allows it to float in value. Countries that use foreign currencies (like Ecuador using dollars) or give up their currency entirely (like eurozone countries using the euro) lose this monetary sovereignty. The institutional details matter, but the basic logic holds across truly sovereign currency systems.
What about inflation? Doesn’t creating money always cause price rises? Money creation only causes inflation when it pushes total spending beyond what the economy can produce. Japan has created enormous amounts of money for decades without significant inflation because they haven’t exceeded their productive capacity.
How does this explain government debt? Government “debt” is simply the money the government has spent into the economy that hasn’t been taxed back out. When you own a government bond, you’re holding money the government created but hasn’t yet destroyed through taxation.
This makes unemployment sound like it’s always the government’s fault. Is that fair? Logically, yes. If people need government money to pay taxes, and unemployment means people can’t get enough government money, then the government hasn’t spent enough into the economy. This doesn’t mean all unemployment is intentional policy.
This seems to give the government enormous power. Is that dangerous? The government already has this power, the question is whether we acknowledge it openly. Pretending the government faces financial constraints that don’t exist can lead to harmful policies like austerity during recessions.