Money, Banking & Financial Systems: Roles, Functions & Demand

TAKEAWAYS:

• Money serves as a medium of exchange, store of value, and unit of account, with its demand driven by transaction, precautionary, and speculative motives (Keynes).
• Banks act as financial intermediaries, creating credit through fractional reserve banking while managing risks like liquidity and solvency.
• The Nepal Rastra Bank (NRB) regulates monetary policy (e.g., repo rate, CRR) to control inflation and economic growth, just as the Federal Reserve does globally.
• E-money (eSewa, Khalti) and digital banking (Ncell Money, Daraz Pay) rely on the same principles of money demand and bank intermediation but with lower transaction costs.
• Financial inclusion (e.g., Ncell’s mobile banking) expands access to credit and savings, reducing inequality, while central bank digital currencies (CBDCs) are emerging globally.
• Worked examples tie theory to real scenarios: calculating opportunity cost of holding money (like saving in Ncell vs. investing in NEPSE) or bank profitability (interest spread between deposit and loan rates).

1. What is Money? Forms, Functions, and Demand

Money is anything widely accepted as a medium of exchange, store of value, or unit of account. It evolved from barter systems (trading goods directly) to commodity money (gold, silver) and now fiat money (currency issued by governments, like Nepali rupees).

Forms of Money

• Commodity Money: Backed by a physical commodity (e.g., gold standard pre-1975).
• Fiat Money: Legal tender with no intrinsic value (e.g., Nepali rupees since 1975).
• E-Money: Digital money stored electronically (e.g., eSewa balance, Khalti wallet).
• Central Bank Digital Currency (CBDC): Digital rupees issued by NRB (pilot in 2024).

Functions of Money

Demand for Money: Keynes’ Motives

John Maynard Keynes identified three motives why individuals and businesses hold money:

1. Transaction Motive:

   • Definition: Demand for money to conduct daily transactions.
   • Example: A shopkeeper in Thamel keeps Rs. 20,000 in cash to buy inventory daily.
   • Formula: $$M_d=k\cdot T$$ Where $M_d$ = Money demanded, $k$ = transactions coefficient, $T$ = total transactions.

2. Precautionary Motive:

   • Definition: Holding money for unexpected expenses (safety buffer).
   • Example: A salary earner keeps Rs. 50,000 in a savings account for medical emergencies.
   • Formula: $$M_d=f(i,Y)$$ Where $i$ = interest rate, $Y$ = income.

3. Speculative Motive:

   • Definition: Holding money to exploit interest rate changes (opportunity cost of bonds).
   • Example: If NRB cuts repo rate, bond prices rise → investors hold cash to buy bonds later.
   • Liquidity Preference Curve:

2. The Banking System: Structure and Functions

Banks are financial intermediaries that connect depositors (savers) with borrowers (investors). In Nepal, the banking system includes:

• Commercial Banks (NMB, Standard Chartered, Global IME)
• Development Banks (AGNISBIR, NIBL)
• Central Bank (Nepal Rastra Bank, NRB)

Functions of Banks

classDiagram
    class Bank {
        +Accept Deposits()
        +Grant Loans()
        +Create Credit()
        +Facilitate Payments()
        +Provide Investment Services()
    }
    class CommercialBank {
        +Offer Savings/Current Accounts
        +Provide Personal/Business Loans
    }
    class CentralBank {
        +Regulate Monetary Policy
        +Issue Currency
        +Supervise Banks
    }
    Bank <|-- CommercialBank
    Bank <|-- CentralBank

Fractional Reserve Banking: How Banks Create Money

Key Formula: $$\text{Total Money Created}=\frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$$ If reserve ratio = 5% (0.05), then: $$\text{Total}=\frac{1000}{0.05}=Rs.20,000\text{ (theoretical maximum)}$$

3. Central Banking: Nepal Rastra Bank (NRB) and Monetary Policy

The Nepal Rastra Bank (NRB) is Nepal’s central bank, established in 2002 (replacing the Nepal Bank). Its key roles:

• Issuing currency (Nepali rupees).
• Regulating commercial banks (licensing, supervision).
• Controlling monetary policy to stabilize the economy.

Tools of Monetary Policy

Impact of Monetary Policy on the Economy

• Higher Repo Rate → Banks borrow more expensive → loan rates rise → borrowing falls → economic slowdown.
• Lower CRR → Banks have more funds to lend → credit expansion → economic growth.

## In the Real World

1. eSewa and Khalti (Digital Money Demand)

   • Idea Used: Transaction and Precautionary Motives
   • How: When you load Rs. 5,000 into eSewa, you’re holding e-money for:
     • Transactions (paying NTC bills, Daraz orders).
     • Precautionary (emergency cash for traffic fines or last-minute groceries).
   • Opportunity Cost: If you keep Rs. 5,000 in eSewa instead of a bank FD (6% interest), you lose Rs. 300/year in interest.

2. Ncell Money and Financial Inclusion

   • Idea Used: Banks as Financial Intermediaries + Fractional Reserve Banking
   • How: Ncell partners with NMB and Standard Chartered to offer:
     • Mobile-based savings accounts (no need to visit a bank).
     • Microloans (e.g., Rs. 20,000 for small businesses) funded by commercial banks.
   • Real Example: A tailor in Kathmandu deposits Rs. 15,000 in Ncell Money, which the bank lends to a restaurant owner at 12% interest. The bank keeps only 5% (Rs. 750) as reserve.

3. NEPSE Stock Market and Speculative Demand

   • Idea Used: Speculative Motive + Liquidity Preference
   • How: Investors hold cash (instead of buying NEPSE stocks) when:
     • Interest rates are high (e.g., NRB repo rate at 7% → bonds are attractive).
     • Market is volatile (e.g., post-earthquake uncertainty in 2015).
   • Worked Example: Suppose the current NEPSE index is 1,800, and a bond offers 8% return. If NRB cuts the repo rate to 5%, bond prices rise → investors sell bonds and buy stocks, pushing the index up.

4. Daraz and Pathao: Credit and Liquidity

   • Idea Used: Bank Loans + Fractional Reserve Banking
   • How: When you use Daraz Credit or Pathao’s "Pay Later", the bank is effectively:
     1. Lending you money (e.g., Rs. 10,000 for a phone).
     2. Creating credit through fractional reserves (only 5% of all loans are backed by deposits).
   • Risk: If too many people default, banks may reduce credit, leading to higher interest rates (like the 2020 COVID-19 loan crisis).

4. Worked Examples (Tied to Real Scenarios)

Example 1: Calculating Opportunity Cost of Holding Money (eSewa vs. Bank FD)

Scenario: You have Rs. 50,000. Should you keep it in eSewa or a bank FD (6% p.a.)?

• If in eSewa:
  • Liquidity: Instant access for transactions.
  • Opportunity Cost: 0% return → You lose Rs. 3,000/year in interest.
• If in Bank FD:
  • Return: Rs. 50,000 × 6% = Rs. 3,000/year.
  • Liquidity: Locked for 1 year (penalty for early withdrawal). Decision: Use eSewa for daily expenses, FD for long-term savings.

Example 2: Impact of CRR Change on Bank Lending

Scenario: NRB increases CRR from 3% to 4%.

• Before: Banks kept 3% of deposits as reserve → Could lend 97%.
• After: Banks keep 4% → Can lend only 96%. Effect:
• Lending capacity drops by 1% → Less money for loans.
• Loan rates may rise (banks charge more to compensate). Real Impact: In 2023, after NRB’s CRR hike, home loan rates increased from 9% to 10.5%.

Example 3: Speculative Demand and NEPSE Stocks

Scenario: NRB cuts repo rate from 7% to 5%.

• Bond Prices Rise: If bonds yield 6%, investors prefer them over stocks.
• Money Demand Shifts: Investors hold more cash to buy bonds later.
• NEPSE Impact: Stock prices fall as demand drops. Graph:

5. Advantages and Disadvantages of the Banking System

6. Key Terms to Remember

mindmap
  root((Money & Banking))
    Forms
      Commodity Money
      Fiat Money
      E-Money
      CBDC
    Functions
      Medium of Exchange
      Store of Value
      Unit of Account
    Demand Motives
      Transaction
      Precautionary
      Speculative
    Banking System
      Commercial Banks
      Central Bank (NRB)
      Fractional Reserve Banking
    Monetary Policy Tools
      Repo Rate
      CRR
      SLR
      OMO

## Exam Tip

1. Keynes’ Motives: Always explain all three motives (transaction, precautionary, speculative) with real examples (e.g., eSewa for transactions, bonds for speculative).
2. Banking Multiplier: Memorize the formula: $$\text{Total Money}=\frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$$ Example: If reserve ratio = 10%, a Rs. 100 deposit creates Rs. 1,000 in total money.
3. NRB Tools: Compare repo rate (short-term) vs. CRR/SLR (long-term liquidity).
4. Graphs: Always label axes and show shifts (e.g., repo rate cut → money demand curve shifts right).
5. Real-World Links: Connect theory to Nepali examples:
   • eSewa → Transaction demand.
   • NEPSE stocks → Speculative demand.
   • NMB loans → Fractional reserve banking.
6. Diagrams: Draw liquidity preference curves and money multiplier flows in exams.

Past Exam Question Practice: Q: What are the motives of demand for money according to Keynes? Explain. A: Keynes identified three motives for holding money:

1. Transaction Motive:

   • People hold money to conduct daily transactions (e.g., buying groceries, paying rent).
   • Example: A salary earner keeps Rs. 20,000 in a current account for monthly expenses.
   • Graph:

2. Precautionary Motive:

   • Money held for unexpected expenses (medical emergencies, car repairs).
   • Example: Saving Rs. 30,000 in a savings account for a hospital bill.
   • Formula: Depends on income (Y) and interest rate (i).

3. Speculative Motive:

   • Holding money to exploit interest rate changes (opportunity cost of bonds).
   • Example: If NRB cuts repo rate, bond prices rise → investors hold cash to buy bonds later.
   • Graph: