Money, Banking & Monetary Policy: Functions, Tools & Impact

TAKEAWAYS:

• Money performs three core functions (medium of exchange, store of value, unit of account) and exists in four forms (currency, demand deposits, time deposits, near-money), with M3 being Nepal’s broadest measure.
• Commercial banks create money through fractional reserve lending, while the Nepal Rastra Bank (NRB) controls money supply via quantitative tools (repo rate, SLR, CRR) and qualitative tools (moral suasion, credit rationing).
• Monetary policy transmission works through interest rates → investment → aggregate demand → inflation/employment, with a lag of 12–18 months—explained via the IS-LM model and Phillips curve.
• Demand-pull inflation (excess AD) can be curbed by contractionary monetary policy (higher repo rate, higher CRR), while cost-push inflation requires supply-side fixes.
• Nepal’s monetary policy challenges include high remittance volatility, dollarization, and the liquidity trap (when NRB cuts rates but banks hoard cash, as in 2020).
• Financial inclusion (e.g., eSewa, Khalti) relies on mobile money and agent banking, but requires NRB’s regulatory sandbox to balance innovation and risk.

What is Money? Functions, Types, and Measures

Money is the lubricant of the economy—without it, trade would collapse into barter. In Nepal, 80% of transactions now use digital money (eSewa, Khalti), yet cash still dominates rural areas (40% of GDP). Let’s break it down.

1. Functions of Money

Money serves three essential roles, visualized below:

graph LR
    A["Money"] --> B["Medium of Exchange"]
    A --> C["Store of Value"]
    A --> D["Unit of Account"]
    B -->|"Example"| E["Buying groceries with Khalti"]
    C -->|"Example"| F["Saving for a house in NMB bank"]
    D -->|"Example"| G["Pricing a Daraz order in NPR"]

• Medium of Exchange: Eliminates the double coincidence of wants (barter’s flaw). In Nepal, eSewa’s 2023 transaction volume hit Rs. 1.2 trillion, proving its efficiency.
• Store of Value: Preserves purchasing power over time. However, hyperinflation in 1990s Nepal (peaking at 20% annually) eroded cash’s value, pushing people to gold and foreign currency.
• Unit of Account: Standardizes prices. Nepal’s GDP is reported in NPR, but Daraz lists prices in USD for global buyers, showing money’s role in relative pricing.

2. Types of Money

Money exists in four forms, ranked by liquidity:

Key Insight:

• M3 is Nepal’s broadest money measure (Rs. 3.8 trillion in 2023).
• eSewa and Khalti are now part of M1 since they are demand deposits (can be spent instantly).

3. Velocity of Money and the Equation of Exchange

The velocity of money (V) shows how often money changes hands. In Nepal:

• V ≈ 4–5 (lower than India’s 6 due to high cash usage).
• The Equation of Exchange links money, velocity, prices, and output: $$MV=PY$$
  • M = Money supply (M3)
  • V = Velocity (~4.5 in Nepal)
  • P = Price level (CPI = 100 in 2023)
  • Y = Real GDP (~Rs. 2.2 trillion in 2023)

Worked Example: Nepal’s Inflation in 2022

• M3 grew by 15% (from Rs. 3.2T to Rs. 3.8T).
• Y grew by 5% (real GDP).
• If V stayed constant, then: $$\frac{M}{M_{-1}}\times \frac{V}{V_{-1}}=\frac{P}{P_{-1}}\times \frac{Y}{Y_{-1}}$$ 1.15 \times 1 = P \times 1.05 \implies P = 1.10 \text{ (10% inflation)} Actual CPI inflation in 2022 was 9.2%, close to our estimate.

How Banks Create Money: Fractional Reserve Banking

Banks don’t just hold deposits—they create money through lending. Here’s how:

flowchart TD
    A["Bank Deposits"] -->|"Rs. 1000 cash deposited"| B["Reserves"]
    B -->|"Holds 10% (SLR)"| C["Required Reserves\n(Rs. 100)"]
    B -->|"Lends 90%"| D["New Loans\n(Rs. 900)"]
    D --> E["Borrower spends Rs. 900"]
    E --> F["New Deposit at Another Bank"]
    F --> G["Money Multiplier Effect"]
    G --> H["Total Money Created = 1/(1-0.10) = Rs. 10,000"]

Key Terms:

• Reserve Ratio (RR): % of deposits banks must hold (Nepal’s SLR = 8.5% for commercial banks).
• Money Multiplier (k): $k=\frac{1}{\text{Reserve Ratio}}$.
  • If RR = 10%, then k = 10 → Rs. 1,000 deposit → Rs. 10,000 money supply.

Real-World Example: NMB Bank’s Lending Boom

• In 2023, NMB’s loan portfolio grew by 18% (Rs. 600B → Rs. 708B).
• If SLR was 8.5%, then every Rs. 100 deposit supported Rs. 1,176 in loans ($1/0.085\approx 11.76$).
• But: High NPLs (non-performing loans) at 2.8% reduced effective money creation.

Central Banking in Nepal: The Nepal Rastra Bank (NRB)

The NRB acts as Nepal’s central bank, controlling money supply via monetary policy tools. Its three core functions are:

1. Issuing Currency: Prints NPR notes (e.g., new Rs. 2,000 note in 2023).
2. Banker to Government: Holds Rs. 1.5 trillion in government securities.
3. Regulator of Commercial Banks: Sets CRR, SLR, and repo rates.

Monetary Policy Tools

NRB uses two types of tools to control inflation and growth:

Visual: NRB’s Policy Transmission Mechanism

sequenceDiagram
    participant NRB
    participant CommercialBanks
    participant Households
    participant Firms

    NRB->>CommercialBanks: Raises Repo Rate to 8.5%
    CommercialBanks->>CommercialBanks: Increase deposit rates to 10%
    CommercialBanks->>Households: Fewer loans approved
    Households->>Firms: Reduced spending
    Firms->>Firms: Lower production
    Firms->>Market: Lower aggregate demand
    Market->>NRB: Inflation falls from 9.2% to 6.8% (2023)

Real-World Impact: NRB’s 2022 Rate Hike

• Before: Inflation at 9.2% (highest since 2016).
• Action: NRB raised repo rate from 7.5% to 8.5%.
• Result:
  • Bank lending rates rose (NMB’s PLR now 11% vs. 9% earlier).
  • Fewer loans for imports → Rs. 50B reduction in trade deficit.
  • Inflation fell to 6.8% by mid-2023.

Inflation and Monetary Policy: Demand-Pull vs. Cost-Push

Inflation is too much money chasing too few goods. NRB fights it via monetary policy, but the cause matters:

Graph: Demand-Pull Inflation in Nepal (2021–2023)

Worked Example: How NRB Cured 2015’s Inflation

• Problem: 12% inflation due to:
  • Demand-pull: High remittances (Rs. 700B in 2015).
  • Cost-push: Fuel price hike (India’s diesel price rise).
• NRB’s Move:
  1. Raised repo rate to 9% (from 6%).
  2. Increased CRR to 5% (from 3%).
• Result:
  • Bank lending fell by 12%.
  • Inflation dropped to 8% by 2016.

Money and Financial Inclusion: eSewa, Khalti, and the Digital Shift

Nepal’s financial inclusion rate is 65% (2023), but rural areas lag at 40%. Digital money (eSewa, Khalti) is bridging the gap.

How Mobile Money Works

flowchart TD
    A["User"] -->|"Deposits Rs. 1000"| B["eSewa/Khalti Wallet"]
    B -->|"Linked to"| C["Commercial Bank\n(NMB, Standard Chartered)"]
    C -->|"Held as"| D["Demand Deposit\n(Part of M1)"]
    D -->|"Used for"| E["Payments, Loans, Investments"]
    E -->|"Loans via"| F["Fintech Partners\n(Khalti Loan, eSewa Credit)"]

Key Stats (2023):

• eSewa transactions: Rs. 1.2 trillion (2023).
• Khalti users: 12 million (40% of Nepal’s population).
• Unbanked population: 35% (mostly rural).

Challenges:

• Liquidity trap: Banks hoard cash instead of lending (seen in 2020).
• Dollarization: 30% of transactions use USD (hurts NRB’s control).
• Cybersecurity risks: Rs. 200M lost to fraud in 2022.

NRB’s Solution: Regulatory Sandbox

• Pilot programs for fintech (e.g., NMB’s AI loan approval).
• Stress tests for banks before launching digital products.

Exam Tip: How to Score Full Marks

1. Define Clearly: Always start with precise definitions (e.g., "Money multiplier is the ratio of total money created to the initial deposit, calculated as $k=\frac{1}{\text{Reserve Ratio}}$").
2. Use Nepal Examples: Examiners love real-world data. Mention:
   • NRB’s repo rate changes (e.g., "In 2022, NRB raised the repo rate to 8.5% to curb inflation").
   • eSewa/Khalti transactions (e.g., "Mobile money now accounts for 60% of retail payments").
3. Draw Graphs: For AD-AS, Phillips curve, or money multiplier, sketch a labeled diagram (even if rough).
4. Compare Tools: In monetary policy questions, contrast:
   • Repo rate vs. CRR (repo affects short-term, CRR affects liquidity directly).
   • Demand-pull vs. cost-push inflation (always link to NRB’s response).
5. Calculate Numerically: If given money supply data, compute:
   • Velocity ($V=\frac{PY}{M}$).
   • Inflation impact (e.g., "If M3 grows by 10% and Y by 5%, what’s inflation?").

Common Mistakes to Avoid:

• ❌ Saying "Central bank prints money" → Wrong! NRB regulates money; commercial banks create it.
• ❌ Confusing SLR and CRR → SLR = liquidity ratio, CRR = cash reserve.
• ❌ Ignoring lags → Monetary policy takes 12–18 months to work.

Final Checklist for Revision: ✅ Can you explain the money multiplier with a real bank’s loan data? ✅ Do you know NRB’s 2023 repo rate and why it changed? ✅ Can you draw AD-AS with a shift and label demand-pull inflation? ✅ Do you understand how eSewa affects M1? ✅ Can you calculate velocity given Nepal’s GDP and M3?