Let’s say you owe £1,000 to your neighbour. What are the ways you can pay it back? The obvious one is to raid your bank account – your existing supply of money. More drastically, you could sell off assets to the value of £1,000.
However, if you are a government, you have another option – create an IOU for £1,000 and sell it to a central bank. That central bank pays for it by printing £1,000. The exact process is a bit more complex in practice but near enough equivalent to you settling your original debt by creating £1,000 out of thin air.
A neat trick, but sadly one that isn’t available to most of us. This type of money creation comes at a price – inflation. As more money starts to circulate, it competes for existing goods and services. The risk is that prices then start rising. Indeed keep printing money as a way of settling debts and you can end up with hyperinflation as people lose faith in the purchasing power of money altogether.