Money, Banking & Trade: Functions, Flows & Global Links

TAKEAWAYS:

• Money’s primary functions (medium of exchange, store of value) and secondary functions (unit of account, standard of deferred payment) are critical for digital payments like eSewa.
• Central banks (Nepal Rastra Bank) control money supply and interest rates—directly affecting loans for Daraz’s inventory or Pathao’s fleet purchases.
• Balance of trade (exports vs. imports) and balance of payments (capital flows) explain why Nepal imports smartphones but exports remittances.
• Commercial banks (NMB, Global IME) use fractional reserve banking to create credit, which fuels Nepal’s construction boom or YouTube’s ad revenue.
• Exchange rates (NPR/USD) impact Daraz’s import costs and NTC’s foreign equipment purchases—tracked via demand-supply curves for forex.
• International trade theories (comparative advantage) explain why Nepal exports jute but imports electronics—visualized via PPF curves.

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1. Money: Functions and Types

Money is the lifeblood of any economy, enabling transactions without barter. It serves four key functions:

Primary Functions

1. Medium of Exchange

   • Money acts as an intermediary in transactions, eliminating the need for double coincidence of wants.
   • Example: When you pay for a Daraz order using eSewa, money (digital or cash) facilitates the exchange without requiring you to own the product first.

2. Store of Value

   • Money retains purchasing power over time, allowing savings for future use.
   • Example: Remittances sent home by Nepali workers in the Gulf are stored as NPR savings, preserving their value until spent.

Secondary Functions

1. Unit of Account

   • Money provides a common measure to value goods and services.
   • Example: Prices of Pathao rides or Ncell data plans are quoted in NPR, making comparisons easy.

2. Standard of Deferred Payment

   • Money allows credit transactions (loans, mortgages) by standardizing future payments.
   • Example: A bank loan for a NEPSE stock purchase is repaid in future installments, using money as the deferred payment standard.

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FIGURE 1: Functions of Money

```mermaid
flowchart TD
    A[Money] --> B[Medium of Exchange]
    A --> C[Store of Value]
    A --> D[Unit of Account]
    A --> E[Standard of Deferred Payment]
    B -->|e.g.| F[Paying for Daraz order via eSewa]
    C -->|e.g.| G[Saving remittances in NPR]
    D -->|e.g.| H[Pricing Pathao rides in NPR]
    E -->|e.g.| I[Repaying NMB loan in installments]

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Types of Money

Money evolves from commodity money (gold, silver) to fiat money (paper/currency backed by government decree). Today, Nepal uses a fiat currency system (NPR), while digital payments (eSewa, Khalti) represent electronic money.

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EXAMPLE: eSewa’s Role as Electronic Money eSewa enables peer-to-peer transactions without physical cash. When you pay a Pathao driver, eSewa processes the transfer instantly, acting as electronic money while NPR remains the fiat currency.

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2. Banking System: Central and Commercial Banks

Banks are the backbone of modern economies, facilitating savings, lending, and monetary policy.

A. Central Bank: Nepal Rastra Bank (NRB)

Functions:

1. Issuer of Currency: Controls money supply (e.g., printing NPR notes).
2. Banker to Government: Manages public debt and treasury operations.
3. Lender of Last Resort: Provides emergency liquidity to commercial banks (e.g., during COVID-19).
4. Regulator of Banks: Ensures stability (e.g., capital adequacy rules for NMB, Global IME).
5. Monetary Policy: Adjusts interest rates (e.g., repo rate) to control inflation.

Tools of Monetary Policy:

• Open Market Operations: Buying/selling government securities to adjust money supply.
• Repo Rate: Interest rate at which NRB lends to banks (currently ~6% as of 2023).
• Cash Reserve Ratio (CRR): Fraction of deposits banks must hold (e.g., 7% in 2023).

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FIGURE 2: Central Bank Functions

```figure
{"type":"bar","labels":["Issues Currency","Banker to Govt","Lender of Last Resort","Regulates Banks","Sets Policy"],"values":[100,80,70,90,85],"ylabel":"Relative Importance (%)","caption":"NRB’s functions ranked by policy impact (2023)"}

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B. Commercial Banks: How They Create Money

Commercial banks (e.g., NMB, Global IME, Standard Chartered) create money through fractional reserve banking.

Process:

1. A customer deposits ₹10,000.
2. Bank holds ₹2,000 (CRR = 20%) and lends ₹8,000.
3. Borrower spends ₹8,000 → new deposit → bank lends ₹6,400 (after CRR).
4. Money Multiplier Effect: Initial ₹10,000 creates ₹50,000 in the economy (1/0.2 = 5).

Formula: $$\text{Money Multiplier}=\frac{1}{\text{CRR}}=\frac{1}{0.2}=5$$

Example: If NRB sets CRR = 10%, a ₹100 deposit can generate ₹1,000 in the economy.

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FIGURE 3: Fractional Reserve Banking

```mermaid
flowchart TD
  A["₹10,000 Deposit"] --> B["₹2,000 CRR"]
  B --> C["₹8,000 Loan"]
  C --> D["₹8,000 New Deposit"]
  D --> E["₹6,400 Loan"]
  E --> F["₹50,000 Total Money"]
  F -->|"Formula"| G["Money Multiplier = 1/CRR"]

Fractional reserve banking with 20% CRR

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Functions of Commercial Banks

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EXAMPLE: Daraz’s Working Capital Loan Daraz needs ₹50 million to stock inventory. It borrows from a commercial bank (e.g., Global IME) at 12% annual interest. The bank uses ₹10 million of customer deposits (CRR = 10%) to lend ₹90 million (after holding ₹10 million). Daraz repays ₹56 million (principal + interest) in 1 year.

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3. International Trade: Balance of Trade and Payments

Trade is the engine of global growth, but imbalances can disrupt economies.

A. Balance of Trade (BOT)

Definition: Difference between exports (goods/services sold abroad) and imports (goods/services bought from abroad).

Types:

1. Favorable Balance of Trade (Trade Surplus): Exports > Imports.
   • Example: Nepal’s jute exports to China (₹5 billion in 2022).
2. Unfavorable Balance of Trade (Trade Deficit): Imports > Exports.
   • Example: Nepal’s smartphone imports (₹20 billion in 2022).

FIGURE 4: Nepal’s Trade Balance (2022)

mermaid
pie title Nepal’s Trade Balance (2022)
    "Exports: ₹100B" : 30
    "Imports: ₹200B" : 70

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B. Balance of Payments (BOP)

Definition: Comprehensive record of all economic transactions between a country and the rest of the world (includes trade, services, capital flows, remittances).

Components:

1. Current Account: Trade (goods/services), income (remittances), transfers.
   • Example: Nepali workers’ ₹50 billion remittances in 2022.
2. Capital Account: Foreign investment, loans, portfolio flows.
   • Example: NEPSE’s ₹1 trillion market capitalization.
3. Financial Account: Changes in foreign assets/liabilities.
   • Example: NTC’s foreign debt for 5G infrastructure.

Types of BOP:

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EXAMPLE: Nepal’s Remittance-Driven BOP In 2022:

• Exports: ₹80 billion (jute, textiles).
• Imports: ₹220 billion (oil, electronics).
• Remittances: ₹50 billion (current account credit).
• Net BOP: (₹80B - ₹220B) + ₹50B = ₹-90B deficit, but remittances partially offset it.

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C. Exchange Rates and Trade

Exchange rates determine the value of NPR against foreign currencies (e.g., USD). They affect trade competitiveness.

Determinants of Exchange Rates:

1. Demand for Imports: High demand for USD (e.g., for oil imports) → NPR depreciates.
2. Remittances: Inflows of USD → NPR appreciates.
3. Foreign Investment: Capital inflows (e.g., NEPSE IPOs) → NPR strengthens.

FIGURE 5: Demand-Supply of NPR/USD

mermaid
pie title NPR/USD Exchange Rate (2023)
    "Demand for USD (Imports)" : 60
    "Supply of USD (Remittances)" : 40

Dashed line: Equilibrium at ₹120/USD.

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EXAMPLE: Oil Import Costs

• 2022: NPR/USD = ₹115. Oil import bill = ₹200 billion (₹100B worth of oil at $60/barrel).
• 2023: NPR/USD = ₹125. Same oil bill now costs ₹220 billion due to NPR depreciation.

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4. International Trade Theories

Theories explain why countries trade and specialize.

A. Absolute Advantage (Adam Smith)

• A country should produce goods where it is most efficient.
• Example: Nepal produces jute (low-cost labor) while importing smartphones (high-cost production).

B. Comparative Advantage (David Ricardo)

• A country should produce goods where it has the least disadvantage.
• Example: Nepal exports textiles (lower opportunity cost than electronics).

FIGURE 6: Comparative Advantage (PPF)

mermaid
pie title Nepal’s PPF (Textiles vs. Electronics)
    "Textiles: 100 units" : 60
    "Electronics: 50 units" : 40

Nepal specializes in textiles (lower opportunity cost).

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C. Terms of Trade

Definition: Ratio of export prices to import prices.

• Favorable: Export prices rise faster than import prices.
• Example: Nepal’s jute prices rise → better terms of trade.

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5. Nepal’s Trade Partners and Barriers

A. Major Trade Partners

B. Trade Barriers

1. Tariffs: Taxes on imports (e.g., 20% tariff on smartphones).
2. Quotas: Limits on import quantities (e.g., sugar imports).
3. Non-Tariff Barriers: Bureaucracy, customs delays.

Example: Nepal’s 20% tariff on smartphones makes them expensive, reducing imports but hurting consumers.

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In the Real World

1. eSewa’s Digital Money

   • Idea: Electronic money (secondary function of money).
   • How: eSewa’s app uses digital tokens to facilitate instant payments, reducing reliance on cash. When you pay a Pathao driver, eSewa acts as a medium of exchange while NPR remains the fiat currency.

2. NEPSE’s Stock Market and Capital Flows

   • Idea: Balance of Payments (Capital Account).
   • How: Foreign investors buying NEPSE stocks (e.g., Ncell, Siddhartha Hospital) contribute to Nepal’s financial account, improving BOP. In 2022, ₹100 billion in foreign investment flowed into NEPSE, partially offsetting trade deficits.

3. Pathao’s Vehicle Loans and Fractional Reserve Banking

   • Idea: Commercial bank lending and money creation.
   • How: Pathao takes a ₹5 million loan from Global IME to expand its fleet. The bank lends ₹5 million using ₹1 million of customer deposits (CRR = 20%). This loan enables Pathao to hire drivers, creating jobs and stimulating the economy.

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Exam Tip

This unit tests conceptual understanding and real-world application. Focus on:

1. Definitions: Know the difference between balance of trade (goods only) and balance of payments (all transactions).
2. Diagrams: Draw demand-supply curves for exchange rates and fractional reserve banking flows.
3. Numerical Problems: Practice money multiplier calculations and BOP balance sheets.
4. Nepal-Specific Examples: Use remittances, NEPSE, or eSewa to explain concepts.
5. Policy Links: Connect NRB’s repo rate to inflation or commercial bank lending to business growth.

Common Pitfalls:

• Confusing absolute advantage (efficiency) with comparative advantage (opportunity cost).
• Forgetting that BOP includes remittances and capital flows, not just trade.
• Misapplying money multiplier (use CRR correctly).

Worked Example for Practice: If NRB sets CRR = 15% and a bank receives ₹200 million in deposits, calculate the maximum money it can create. Solution:

1. Legal Reserve = ₹200M × 15% = ₹30M.
2. Loanable Funds = ₹200M - ₹30M = ₹170M.
3. Money Multiplier = 1/0.15 ≈ 6.67.
4. Total Money Created = ₹170M × 6.67 ≈ ₹1,133.9M.

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FIGURE 7: Money Multiplier Calculation