How Central Bank creates money?
The central bank cannot create money at its hunch. It cannot print money and distribute to the public to make them happy. Neither it can print more to supply it to the governments as per the government's wish. There are certain predefined rules and mandates defined by laws for every central banks. Central banks can create money through two channels only: i) by purchasing foreign exchange from government, banks and individuals and ii) by providing loans to government, banks and government enterprises. Can it give as much loan as it likes? No. Not during normal times.
A clear distinction is to be made between how much the central bank can print money and how much it can send it to the market (circulation). Clearly, it can print as much as it likes (e.g. for 5 years right now). But all of the money printed cannot be used by the government and public. Suppose that the central bank of Nepal (NRB) prints Rs. 1000-rupee notes totaling Rs. 100 billion and keeps in its vault. No one can spend that money until the central bank gives it to the market. There are only two ways the central bank can bring the printed money in circulation: buying foreign currency from the market and providing loan to the banks and government.
Central banks can use the money to buy US dollar and other foreign currencies from the market. If remittance inflow is very high, a lot of US dollar is accumulated at banks which they can sell to the central bank to get local currency. This process is called foreign market intervention. So, higher remittances mean higher currency in circulation and higher money is printed and circulated in the economy.
This is the story happening in Nepal from 2024 to 2026. Due to high inflow of remittances, the NRB is buying a lot of foreign exchange from the market and giving Nepali rupees to the market. It can be seen in the Net Foreign Exchange Reserves item of the balance sheet of NRB. The foreign exchange asset increased by Rs.1058 billion during 2025/26, which roughly says that NRB circulated that much new money (either in physical cash or digital form) in the market.
Is there any limit to this process of buying money from the market? In flexible exchange rate regime, central banks do not buy/sell foreign exchange, except in extreme volatile conditions. But in fixed exchange rate regimes, central banks have a commitment to keep the exchange rate stable and are compelled to buy as much amount as supplied by the market at the prevailing rate. If central bank feels that there is a lot of money in the market due to buying of foreign reserves, they can mop-up the liquidity by selling government securities or their own bonds (called open market operations or sterilization).
The only constraint for increasing the currency in circulation is that central banks have to maintain some collateral for the money brought to circulation. In case of Nepal, such collateral should be a mix of foreign exchange (at least 50%) and other instruments including Nepali rupee. Since buying foreign exchange never creates any hurdle regarding the collateral during the money creation process, NRB has no limits to create money through this channel (though it is not desirable for the price stability objective). And again, it depends on factors outside the control of NRB (i.e. on remittance flows).
The other method central bank can create money is by providing loans to the government, banks and financial institutions and government enterprises. However, central bank does not have much control in this process. The loan to the government cannot exceed certain threshold and will be as specified in the Central Bank Act. For example, NRB cannot provide overdraft facility to the government beyond 5% of previous year revenue and cannot hold government securities more than 10 percent of the previous year revenue. And more importantly, for taking the overdraft, the government account balance should turn negative, which is not the case during normal times and if loan is taken, it should be paid back within a year. Central banks can provide loans to banks and other public institutions but for very short-term liquidity purpose only. And they require government securities as collateral for providing such loans. Since banks hold a limited amount of government securities, even this method puts a lot of limits for expanding central bank money.
Then who creates billions and trillions of money in the economy? It is the commercial banks and other banks that create money by providing loans to public as well as institutions. People believe banks and keep their cash at banks. Banks believe people and give that cash as loans. The same 1000 rupee note that I had with me is now my deposit which I can withdraw and spend at any time and which is being used by other people in the form of loan at the same time. From this process, banks create a lot of money in the form of secondary deposits.
How much money can the banks create? It is clear if we see the balance sheet of the banks and financial institutions. Total money supply in the economy is equal to the amount of cash at the hands of public and the deposits maintained in the financial system. Most of these deposits are created from the loans provided from other peoples' money as such no issuance of new money either in hard form or digital form is required by the central bank.
Does it mean that central banks are powerless? 'No'. The central banks cannot create much money by themselves (not even efficient to do so) but can largely control the money creating machine of another powerful player (the commercial banking system). Central banks control money creation by using a lot of traditional as well as modern tools. Such tools range from the cash reserve ratio, policy rate, open market operations, and refinance facilities to credit deposit ratio, loan to value ratio, leverage ratio and liquidity ratios. Thus, the central bank has the key to control the money creation process and the banking system creates the large part of the money supply.
Most importantly, 'Public Trust' is at the heart of this money creation process. Most of the money in the economy is derived from other peoples' money. If all depositors of a bank claim their deposits back in currency, no bank across the world can pay such deposits and the bank heads for an immediate run. It is because the bank has already given the money as loans, which cannot be called back. Not all, even the 10-20 % of the deposits cannot be converted to cash because the banks do not hold that much cash with them. The bank can go to the interbank market or use the liquidity facility from the central bank for managing extra cash, but that will not be enough to pay the deposits. So, the only end result will be the bank run if trust is confidence in the banking system is not restored. That's why the regulators of the banking system need to be highly professional, and credible. They are often separated from the political institutions such as the elected governments and given a mandate to work for stability over a long horizon. If these institutions become fragile and public trust on banks is lost, the country has to bear a huge cost in the form of bailout program, either from the taxpayer's money or borrowing from international institutions.
