This is how I understand that the process works. First of all, one has to understand that commercial banks and governments, via their central bank, work in lock step to make this process work.
When a government wants to create money they do not do anything as crude as printing more notes. The central bank writes a cheque on itself. It has nothing to back this up, of course, but governments have given central banks the power to do this. The central bank then goes into the open market and purchases something. It could be anything, but normally it is their own debt, government bonds. The people who have sold the assets to the central bank then deposit their cheques with a commercial bank. Hey presto, new money has been created! The commercial banks then places their cheques on the central bank.
The government has now created something out of thin air, but it is this ability to create money out of nothing plus the multiplier effect of fractional reserve banking that turns this into a truely awesome process of credit expansion.
As soon as the commercial banks have received the cheques from whomever the government has purchased assets, the capital base of the banks is increased. The commercial banks can now lend out against this capital base on the assumption that not everyone will want their money at the same time. This is fractional reserve banking. Let us say that the banks require a capital base of 2%. This means that the banks can then lend out 50 times the money that the government had created out of nothing initially.
As an example, there was something in the UK press a couple of weeks ago that the Bank of England would inject £50bn into the banking system. No one asked where this money was coming from and £50bn is a lot of money. But £50bn times 50 would be two and a half trillion pounds. Now we are talking serious money.
So, that is my understanding as to how the banks create money; and it is banks in the plural: commercial banks and central banks. I am sure there are better qualified than me who will add more detail and I look forward to reading their posts.
On the subject of fractional reserve banking, I think it is worth mentioning that throughout history, there has been a distinction between deposits for safekeeping, and deposits that are loans. Laws going back to Greek and Roman times have upheld this distinction: money deposited for safekeeping should be treated the same way as goods deposited in a warehouse, to be constantly available and not to be leant out. Banks have always been tempted to lend out though, and in the past the penalties have been severe, including execution of bankers in Spain. However, more recently, laws have been passed legalizing this fraudulant activity and the result is the fractional reserve banking we now see. The big beneficiaries of this have been the banks themselvers for whom credit expansion is extremely profitable, and governments (which passed these laws in the first place) who have been amongst the first and biggest beneficiaries of the increased ability to borrow. It is also worth saying that banks have not been able to perform this fractional reserve banking without government support. Historically, without the government monopoly on the issue of fiat currency and a central bank to act as lender of last resort, the commercial banks would soon go bust.
On the process of credit expansion I recommend Murray Rothbard’s “The case against the Fed”. And on the historical distinction between deposits for safekeeping and deposits for loans I recommend Jesus Huerta de Soto’s “Money, Bank Credit and Economic Cycles”.