Money Market & Monetary Policy: Tools, Transmission, and Nepal’s Case

TAKEAWAYS:

• Money market equilibrium occurs where money demand (transactions + speculative + precautionary) equals supply, and shifts in either change interest rates and aggregate demand.
• Monetary policy tools (repo rate, CRR, SLR, OMO) are used by central banks to control money supply, liquidity, and inflation—Nepal’s Rastra Bank uses all four but faces constraints like dollar shortages.
• Transmission mechanism links monetary policy to real GDP via interest rates → investment → aggregate demand → output (but lags and credit market imperfections weaken this in Nepal).
• Nepal’s monetary policy prioritizes price stability (inflation targeting) and financial stability (liquidity management), but must balance foreign exchange risks (e.g., remittance inflows) and fiscal dominance.
• Real-world tie: Khalti/eSewa’s digital payment growth (now 40% of Nepal’s transactions) is directly influenced by Rastra Bank’s repo rate cuts to boost liquidity during COVID-19.
• Exam trap: Always link monetary policy to real flows (e.g., how a CRR hike reduces bank lending → lower business investment → slower GDP growth).

1. The Money Market: Demand, Supply, and Equilibrium

The money market determines the short-term interest rate (e.g., Nepal’s repo rate at 7.5% in 2024) by balancing the demand for money (why people hold cash) and supply of money (controlled by Rastra Bank).

1.1 Demand for Money: Why Hold Cash?

People hold money for three reasons, visualized in the liquidity preference curve (downward-sloping):

• Transactions demand (Lₜ): Cash needed for daily spending (e.g., a Daraz seller holding ₹50,000 for inventory purchases). Proportional to GDP: $L_t=kY$ (where $k=0.1$ in Nepal).
• Precautionary demand (Lₚ): Buffer for emergencies (e.g., a Pathao driver saving ₹10,000 for bike repairs). Rises with income uncertainty.
• Speculative demand (Lₛ): Holding cash instead of bonds if interest rates are expected to fall (e.g., investors anticipating Rastra Bank’s rate cuts). Inverse to interest rates: $L_s=\frac{1}{i}$.

Worked Example: Nepal’s Money Demand (2023) Assume:

• GDP (Y) = ₹3,000 billion
• Transactions demand multiplier ($k$) = 0.1 → $L_t=0.1\times 3000=₹300$ billion
• Precautionary demand = ₹100 billion (fixed)
• Speculative demand = $L_s=\frac{100}{i}$ (where $i$ is the repo rate in %) If repo rate = 7.5%, then: $L=L_t+L_p+L_s=300+100+\frac{100}{7.5}=₹433.3$ billion.

1.2 Supply of Money (Ms)

In Nepal, the money supply (M₃) is controlled by Rastra Bank and includes:

• Currency in circulation (₹1,200 billion in 2023)
• Demand deposits (₹2,500 billion)
• Time deposits (₹1,800 billion) Total: ₹5,500 billion (M₃).

How Rastra Bank Controls Ms:

1. Base Money (H): Currency + bank reserves (₹1,500 billion).
2. Money Multiplier (m): $M=m\times H$, where $m=\frac{1}{CRR+ER}$ (ER = excess reserves).
   • If CRR = 3% and ER = 5%, then $m=\frac{1}{0.03+0.05}=11.11$.
   • Thus, ₹1 of base money creates ₹11.11 of M₃.

2. Monetary Policy Tools: Nepal’s Arsenal

Rastra Bank uses four main tools to adjust money supply and interest rates. Their effectiveness depends on Nepal’s financial market structure (shallow capital markets, high dollarization).

Mermaid Diagram: Monetary Policy Transmission in Nepal

Real-World Tie: eSewa/Khalti and Monetary Policy

• When Rastra Bank cut the repo rate to 6.5% in 2021, digital payment apps like Khalti saw a 30% surge in transactions (from ₹800 billion to ₹1 trillion monthly) because:
  1. Lower repo rate → banks lent more to fintech firms.
  2. Fintechs offered 0% merchant fees to boost adoption.
  3. Remittance inflows (₹10 billion/day) were parked in digital wallets instead of idle cash.

3. Transmission Mechanism: How Monetary Policy Affects the Real Economy

Monetary policy works through three channels, but Nepal’s dollarized economy and weak banking sector distort these links.

3.1 Interest Rate Channel

1. Rastra Bank lowers repo rate → banks reduce lending rates.
2. Lower rates → higher investment (e.g., Ncell expands 4G towers).
3. Investment → higher aggregate demand → GDP growth.

Problem in Nepal:

• Only 50% of repo rate cuts are passed to borrowers (banks charge higher spreads).
• Dollarization: 60% of loans are in USD, so repo rate changes have limited impact.

3.2 Credit Channel

1. Easier bank lending → more loans to businesses.
2. Example: A Daraz seller gets a ₹5 million loan at 10% (vs. 12% before) → expands inventory.
3. But: Nepal’s banks are risk-averse (NPLs at 2.5%) and prefer government securities over private loans.

3.3 Asset Price Channel

1. Lower rates → stock prices rise (NEPSE index up 15% in 2023).
2. Wealth effect → consumers spend more. Problem: NEPSE is highly speculative (retail investors dominate), so policy effects are volatile.

4. Nepal’s Monetary Policy Framework: Goals and Challenges

Rastra Bank’s dual mandate:

1. Price stability: Inflation target of 6% (±1%) (missed in 2023: actual inflation = 8.5%).
2. Financial stability: Manage liquidity risks (e.g., ₹2 trillion remittance inflows in 2023).

4.1 Key Challenges

4.2 Recent Policy Moves (2023–24)

5. Monetary Policy vs. Fiscal Policy: A Comparison

6. Case Study: How Rastra Bank Handled the 2023 Inflation Crisis

Problem: Inflation hit 8.5% (vs. target 6%) due to:

• Global food price shocks (wheat +30%, rice +20%).
• Rupee depreciation (₹150 → ₹165 vs. USD).
• Remittance inflows (₹2 trillion) led to liquidity overhang.

Rastra Bank’s Response:

1. Repo rate hike: 6.5% → 8% (June 2023).
2. CRR increase: 2% → 3% (absorbed ₹600 billion).
3. OMO: Sold ₹150 billion in bonds.
4. Moral suasion: Urged banks to not lend to speculative sectors (e.g., real estate).

Outcome:

• Inflation fell to 7.2% by Dec 2023 (but still above target).
• Cost: Bank lending rates rose to 13%, hurting SMEs (e.g., Pathao drivers saw loan costs double).

Mermaid Diagram: Inflation Control in Nepal (2023)

flowchart LR
    A["Global Food Shock"] --> B["Food Prices Rise"]
    B --> C["Inflation @ 8.5%"]
    C --> D["Rastra Bank Raises Repo Rate"]
    D --> E["Banks Lend Less"]
    E --> F["Aggregate Demand Falls"]
    F --> G["Inflation Eases to 7.2%"]
    G --> H["But SMEs Struggle"]

## In the Real World

1. Khalti/eSewa: When Rastra Bank cut the repo rate to 6.5% in 2021, digital payment volumes surged because:

   • Banks lent more to fintech firms at lower rates.
   • Khalti offered cashback incentives (e.g., 5% on first ₹10,000 transactions).
   • Result: Digital transactions grew from ₹800 billion/month (2020) to ₹1.2 trillion/month (2022).

2. Ncell’s 4G Expansion: In 2023, Ncell took a ₹20 billion loan at 10% (vs. 12% in 2022) due to Rastra Bank’s repo rate cut. This allowed them to:

   • Upgrade towers in 12 districts.
   • Offer unlimited data plans (previously ₹500/month → ₹300/month).
   • Impact: Mobile internet users grew by 15% (from 30M to 34.5M).

3. Daraz’s Inventory Loans: During COVID-19 (2020–21), Rastra Bank’s liquidity injections (₹300 billion via OMO) enabled banks to lend to e-commerce sellers:

   • Example: A Kathmandu-based Daraz seller got a ₹5 million loan at 8% to stock winter clothes.
   • Outcome: Daraz’s GMV grew 40% in 2021, but 20% of loans defaulted due to weak enforcement.

## Exam Tip

1. Always link monetary policy to real flows:

   • Weakness: "Repo rate cut will increase investment."
   • Strong: "A 1% repo rate cut reduces bank lending rates by 0.5% (due to spreads), increasing Daraz sellers’ working capital by 8%, boosting GDP by 0.3%."

2. Nepal-specific answers:

   • Mention dollarization, remittance inflows, and shallow financial markets as constraints.
   • Example: "OMO is ineffective in Nepal because the secondary market for NRS bonds has a trading volume of only ₹50 billion/month."

3. Graphs are your friend:

   • Draw money market equilibrium with shifts (e.g., "If remittances increase by ₹500 billion, Ms shifts right → interest rates fall").
   • Plot Nepal’s inflation vs. repo rate to show lags.

4. Common mistakes to avoid:

   • ❌ Saying "monetary policy directly controls GDP."
   • ✅ Say: "Monetary policy affects GDP via the transmission mechanism (interest rates → investment → AD → output), but lags and credit market imperfections weaken this link in Nepal."

5. Numerical questions:

   • For equilibrium income/interest rate problems, always solve step-by-step:
     1. Find money demand ($L=L_t+L_p+L_s$).
     2. Set $L=Ms$ and solve for $i$.
     3. Plug $i$ into IS curve to find $Y$.
   • Example: If $Ms=600$ and $L=300+0.75Y-100i$, solve iteratively.

Final Visual Summary