Money & Banking: Interest Rates, Monetary Policy & Nepal’s Tools

TAKEAWAYS

• Interest rates are the "price of money": nominal rates include inflation, while real rates reflect true borrowing costs (e.g., Ncell’s loan ads show nominal rates, but your actual cost depends on inflation).
• Monetary policy tools (repo rate, CRR, SLR, open market operations) are how the NRB steers the economy—like adjusting a car’s throttle to avoid skidding (inflation) or stalling (recession).
• Money supply (M1, M2, M3) grows when banks lend, but the NRB controls this via reserve requirements and liquidity adjustments (e.g., when NRB cuts CRR, banks lend more, boosting Daraz’s working capital).
• Inflation targeting (NRB’s 6%±1% goal) uses interest rates: higher rates cool demand (demand-pull inflation), lower rates spur investment (cost-push inflation).
• Liquidity traps (when even zero rates fail to stimulate growth) explain why Nepal’s 2020 COVID-19 stimulus required fiscal policy (budget deficits) alongside monetary easing.
• Exchange rates are indirectly tied to monetary policy: if NRB raises rates, foreign investors buy Nepalese rupees (appreciation), hurting exporters like Himalayan textiles.

1. Money: Definition, Functions, and Supply in Nepal

Money is anything widely accepted as payment for goods/services or repayment of debt. In Nepal, it includes:

• Currency: Rs. notes and coins (issued by NRB).
• Demand deposits: Savings/current accounts at banks (e.g., NMB, Global IME).
• Time deposits: Fixed-term deposits (e.g., 1-year CDs at Siddhartha Bank).

Functions of Money

mindmap
  root((Money))
    Functions
      Medium of Exchange["Trades goods/services without barter (e.g., buying groceries with eSewa money)"]
      Store of Value["Saves purchasing power (e.g., Rs. 100 today ≈ Rs. 95 in a year if inflation=5%)"]
      Unit of Account["Measures value (e.g., a Daraz phone costs Rs. 25,000)"]
      Standard of Deferred Payment["Enables loans/credit (e.g., Ncell’s ‘Pay in 3 months’)"]

Money Supply in Nepal: M1, M2, M3

Nepal Rastra Bank (NRB) classifies money supply as:

Why it matters: When NRB wants to stimulate growth, it increases M3 by cutting Cash Reserve Ratio (CRR) or Statutory Liquidity Ratio (SLR), freeing up bank loans for businesses like Daraz or Pathao.

2. Interest Rates: Nominal vs. Real

Interest rates are the cost of borrowing or return on lending. Two key types:

A. Nominal Interest Rate (i)

• Definition: The stated rate on loans/deposits (e.g., 8% on a NMB loan).
• Formula: $$\text{Nominal Interest}=\text{Real Interest}+\text{Inflation Premium}$$
• Example: If inflation = 5% and the real cost of borrowing is 3%, the nominal rate = 8%.

B. Real Interest Rate (r)

• Definition: Adjusts for inflation to show the true cost of borrowing.
• Formula (Fisher Equation): $$1+i=(1+r)(1+\pi )\text{or}r\approx i-\pi$$ (For small $\pi$, $r=i-\pi$.)
• Example: If you borrow Rs. 100,000 at 8% nominal and inflation is 5%, your real cost is: $$r=8\%-5\%=3\%$$ You repay Rs. 108,000, but due to inflation, Rs. 108,000 buys only what Rs. 105,000 bought before. Net cost = 3%.

Why This Matters for Nepal

• Banks advertise nominal rates (e.g., 9% on home loans), but your real burden depends on inflation.
• NRB’s repo rate (currently 8.5%) is a nominal rate that influences all other rates in the economy.
• Negative real rates (when $i<\pi$) can encourage borrowing (e.g., 2021: repo rate = 6%, inflation = 4% → $r=2\%$), but if inflation spikes to 7%, $r=-1\%$, making loans artificially cheap.

CURVE: Nominal vs. Real Interest Rates in Nepal (2018–2023)

3. Demand for and Supply of Money

The money market determines interest rates via liquidity preference (Keynes) or loanable funds (classical).

A. Demand for Money (Liquidity Preference)

Keynes identified three motives for holding money:

1. Transaction motive: For daily purchases (e.g., Rs. 5,000 in your eSewa wallet).
2. Precautionary motive: For emergencies (e.g., Rs. 20,000 in a savings account).
3. Speculative motive: To exploit interest rate changes (e.g., parking cash in T-bills if repo rates rise).

Demand for money ($M_d$) depends on:

• Income (Y): Higher income → higher transaction demand.
• Interest rate (i): Higher $i$ → more speculative demand (opportunity cost of holding cash rises).

Equation: $$M_d=L(Y,i)=kY-hi$$ (Where $k$ = transactions coefficient, $h$ = sensitivity to interest rates.)

B. Supply of Money ($M_s$)

Controlled by NRB via:

• Monetary base: Currency + bank reserves.
• Tools: CRR, SLR, repo rate, open market operations (OMO).

Supply curve is vertical (assumed fixed in short run): $$M_s=\text{Fixed by NRB}$$

Equilibrium in Money Market

Real-world example: When NRB cut the repo rate from 8.5% to 7.5% in 2023, banks reduced lending rates (e.g., NMB’s personal loan rate fell from 12% to 10%). This increased money demand for transactions, but the lower cost of borrowing also boosted investment in sectors like renewable energy.

4. Tools of Monetary Policy

NRB uses four main tools to control $M_s$ and $i$:

PROCESS: How NRB Adjusts Liquidity

5. Monetary Policy Objectives in Nepal

NRB’s primary goals (from Monetary Policy Framework, 2019):

1. Price Stability: Target inflation of 6% ±1% (achieved via interest rates).
2. Economic Growth: Support GDP growth (~7% target).
3. Financial Stability: Prevent bank runs or asset bubbles.
4. Exchange Rate Stability: Manage Rs. depreciation against USD.

Case Study: NRB’s Response to COVID-19 (2020)

DATA: Nepal’s Monetary Policy Tools (2018–2023)

In the Real World

1. eSewa and Khalti

   • Idea: Transaction demand for money.
   • How: When you load Rs. 5,000 into eSewa, you’re holding digital cash for transactions. If NRB raises interest rates, you might shift funds to fixed deposits (higher speculative demand), reducing eSewa’s liquidity.

2. Ncell’s "Pay in 3 Months" Loans

   • Idea: Real vs. nominal interest rates.
   • How: Ncell advertises 0% EMI, but the real cost is hidden in the nominal interest rate (e.g., 12% on the underlying loan). If inflation is 5%, your real cost is 7%. NRB’s repo rate affects these loan rates: when repo rises, bank lending rates rise, making Ncell’s financing more expensive.

3. Daraz’s Working Capital Loans

   • Idea: Money supply and credit creation.
   • How: When NRB cuts CRR, commercial banks like Standard Chartered Nepal lend more to Daraz for inventory. In 2020, lower CRR (3%) helped Daraz expand by 30% during the pandemic. Conversely, in 2022, higher CRR (4%) reduced Daraz’s borrowing power, slowing growth.

4. Nepal’s Remittance Boom (2021–2023)

   • Idea: Liquidity and exchange rates.
   • How: When NRB raised repo rates in 2022, foreign investors bought Nepalese rupees (seeking higher yields), causing the Rs. to appreciate by 3% against the USD. This hurt exporters (e.g., carpet makers) but helped importers (e.g., fuel, electronics).

5. Kathmandu Traffic Jams

   • Idea: Liquidity traps and fiscal limits.
   • How: During COVID-19, NRB cut rates to 5.5%, but businesses still struggled due to lockdowns. This showed a liquidity trap: even zero rates couldn’t stimulate demand. The government had to step in with fiscal policy (budget deficits) to fund road repairs and public transport.

6. Monetary Policy vs. Fiscal Policy

When to Use Which?

• Use monetary policy for:
  • Controlling inflation (e.g., 2022: NRB raised rates to tame 6.8% inflation).
  • Adjusting short-term liquidity (e.g., festival season cash shortages).
• Use fiscal policy for:
  • Long-term growth (e.g., Provincial Road Fund for infrastructure).
  • Redistribution (e.g., progressive taxes to fund health care).

WORKED EXAMPLE: How a Repo Rate Hike Affects You Scenario: NRB raises the repo rate from 7.5% to 8.5% to control inflation.

1. Banks Borrow More Expensively:

   • Before: Banks borrowed from NRB at 7.5% → lent to you at 10%.
   • After: Banks borrow at 8.5% → lend to you at 11%.

2. Your Loan Costs Rise:

   • If you took a Rs. 1,000,000 home loan at 10%, your EMI was Rs. 10,609/month.
   • Now at 11%, EMI rises to Rs. 11,051/month → Rs. 360 more/month.

3. Savings Accounts Earn More:

   • Your fixed deposit rate rises from 8% to 9% → Rs. 900 extra/year on Rs. 100,000.

4. Businesses Slow Down:

   • Daraz’s working capital loan rate rises → slower inventory expansion.
   • Pathao drivers may see fewer loan options for bikes.

5. Inflation Cools:

   • Higher borrowing costs → lower spending → demand-pull inflation falls.

GRAPH: Transmission Mechanism of Monetary Policy

7. Limitations of Monetary Policy

Monetary policy isn’t always effective due to:

1. Liquidity Trap (Keynes):

   • Problem: Even at zero interest rates, people/businesses won’t borrow (e.g., 2020 COVID-19).
   • Example: In 2020, NRB cut rates to 5.5%, but businesses still didn’t invest due to uncertainty.

2. Time Lags:

   • Recognition lag: NRB takes time to spot inflation/unemployment.
   • Implementation lag: Changing CRR/repo rate takes weeks.
   • Impact lag: Effects on GDP/inflation take 6–18 months.

3. Inequality:

   • Higher interest rates hurt borrowers (e.g., small farmers, SMEs) more than savers.

4. Exchange Rate Effects:

   • Higher rates → stronger rupee → hurts exporters (e.g., carpet industry).

DATA: Nepal’s Monetary Policy Challenges

Exam Tip

How to Score Full Marks in TU/PU Exams

1. Define Clearly:

   • Always start with precise definitions (e.g., "Monetary policy refers to the central bank’s use of tools like repo rates, CRR, and OMO to control money supply and achieve macroeconomic goals like price stability and full employment.").

2. Use Nepal Examples:

   • Examiners love real-world applications. For every concept, link it to NRB, eSewa, Daraz, or inflation data.
   • Example:

     "When NRB raised the repo rate from 7.5% to 8.5% in 2023, banks increased lending rates, reducing consumer spending and helping to control inflation from 6.8% to 5.9%."

3. Diagrams Are Mandatory:

   • Always draw:
     • Money market equilibrium (supply-demand).
     • Transmission mechanism of monetary policy.
     • Bar charts of CRR/repo rate changes.
   • Label every axis, curve, and shift (e.g., "Ms shifts right when NRB buys bonds").

4. Compare Tools:

   • For questions on how to control inflation, compare:
     • Monetary: Raise repo rate → higher lending rates → lower AD.
     • Fiscal: Increase taxes → lower disposable income → lower AD.
   • Use a table to contrast effects.

5. Numerical Questions:

   • For equilibrium interest rate problems:
     1. Write down money demand and supply equations.
     2. Set $M_d=M_s$ and solve for $i$.
     3. Interpret: "At equilibrium, the interest rate is 5%, meaning banks lend at this rate to meet demand."

6. Case Study Tips:

   • If given Nepal’s GDP growth or inflation data, relate it to monetary policy:

     "The 2022 inflation spike (6.8%) forced NRB to raise the repo rate to 8.5%, which successfully brought inflation down to 5.9% in 2023 by reducing aggregate demand."

7. Common Mistakes to Avoid:

   • ❌ Saying "monetary policy controls fiscal policy" (they’re independent).
   • ❌ Ignoring real vs. nominal interest rates in loan calculations.
   • ❌ Forgetting to mention NRB’s dual mandate (price stability + growth).

PAST EXAM QUESTION TRACE (2022 PU Paper) Question: "Explain how an increase in the Cash Reserve Ratio (CRR) affects the money supply in Nepal. Use a numerical example with initial deposits of Rs. 1,000 billion and a required reserve ratio of 10% before and after the CRR hike to 15%."

Model Answer:

1. Definition:

   "CRR is the percentage of deposits banks must hold as reserves with NRB. Increasing CRR reduces the money multiplier, shrinking the money supply."

2. Initial Scenario (CRR = 10%):

   • Initial deposit (D): Rs. 1,000bn.
   • Required reserves: 10% of D = Rs. 100bn.
   • Excess reserves: Rs. 900bn → lent out.
   • Money multiplier: $1/0.10=10$.
   • Total money created: $1,000bn\times 10=Rs.10,000bn$.

3. After CRR Hike (CRR = 15%):

   • Required reserves: 15% of D = Rs. 150bn.
   • Excess reserves: Rs. 850bn → lent out.
   • Money multiplier: $1/0.15\approx 6.67$.
   • Total money created: $1,000bn\times 6.67=Rs.6,670bn$.

4. Impact:

   • Money supply falls from Rs. 10,000bn to Rs. 6,670bn → contractionary effect.
   • Real-world link: "This is why NRB raised CRR to 4% in 2023 to absorb excess liquidity and curb inflation."

5. Graph:

Final Checklist for Exam Answers: ✅ Definitions (1 mark each). ✅ Diagrams (3 marks). ✅ Nepal examples (2 marks). ✅ Numerical workings (3 marks). ✅ Policy implications (2 marks).