The most common mechanism used to generate money is typically called the money multiplier. It measures the amount by which the commercial banking system increases the money supply. To control the amount of money created by the system, central banks place reserve ratios on the commercial banks which set the proportion of primary deposits the banks may not lend out. In the USA this ratio is 10%, in other countries there is no reserve ratio eg. the UK. The reserve ratio is to prevent banks from 1) having a shortage in money when a large demand of deposits is withdrawn 2) limited the amount of money that will be generated. The reserve ratio is determined by the Fed (Federal Reserve) and can be altered.
This system works as follows.
For example, let's assume that a primary deposit ie. cash of $100,000 is made into bank A. If the cash reserve ratio is 10%, then $10,000 must be kept on hand by the bank ($10,000 is 10% of $100,000) and up to $90,000 of new loans can be issued by the bank. When the $90,000 worth of loans are deposited back into the bank, this sum is added to the reserves of the bank and a further $81,000 ($81,000 is 90% of $90,000) can then be loaned by the bank out of those accounts.
An example of the creation of new money:
The following steps describe one way that new money can be created. It is an example from the US.
The government issues a Treasury security. This is simply an IOU, a promise to pay the holder a specified sum of money on a particular date. In this example, let's say the government issues $1,000,000 worth of bonds.
The Federal Reserve prints a check, in the amount of $1,000,000 and makes it payable to the government. This check is the proceeds from the sale of the bonds.
The $1,000,000 of bonds is recorded as an asset by the Fed. (money owed to the central bank is called an "asset" by the bank) It is assumed the government, with its power to tax, will make good on its debt (this is why the people buying the bonds from the fed consider it a risk-free investment). The Fed can sell these bonds which are a liability of the government. Individual investors, pension funds, mutual funds, insurance agencies, banks, foreign government central banks, can all buy the bonds, effectively loaning money to the treasury. They do this to invest their money and receive interest in return.
The government deposits the check in its own account. The government hires employees and buys things with the $1,000,000, and it does so by writing government checks. These government checks are then deposited in commercial banks. For the sake of simplicity, assume it all goes into one commercial bank, which has a zero balance to begin with.
The commercial bank now claims $1,000,000 in new liabilities (the amount on deposit in a bank is called a "liability" by the bank, because the bank has to pay interest to it, amongst other things). In the US, the law allows the bank to makes loans so longs as it retains a 10% cash reserve. This lending of money that it has on deposit is the precise point at which new money is created, because the depositor still has his money, and the person getting the loan now has money too. If the $1,000,000 is held by the bank as notes then it can lend $900,000 to borrowers.
$900,000 is loaned for various purposes eg. to buy a house. These loans are in the form of money transfer. The bank transfers the money to the buyer's attorney who transfers it to the seller, who deposits it right back into the bank. Note however, in real life that money would only come from the bank temporarily, which then would issue its own bonds or use a company like Fannie Mae to issue its own bonds, so that again investors can actually lend the money while the bank is simply a middleman, called a "servicer".
The commercial bank now claims $900,000 in new liabilities. This money is put into reserves, and 90% of that, or $810,000 is lent out. As soon as the $810,000 is deposited back into the bank, the cycle repeats and repeats until there are no more borrowers.
The total amount lent out to borrowers is $900,000. Add that to the $100,000 that it still has on deposit and the total is $1,000,000.
To summarise money is created when banks/financial institutions lend the moneys deposited with them.