Money, Banking, Inflation: Functions, Instruments, Policies

Key Concepts and Definitions

What is Money?

Money is anything that is generally accepted as payment for goods and services and performs three key functions:

1. Medium of Exchange: Eliminates the need for barter (e.g., trading rice for clothes).
2. Store of Value: Holds purchasing power over time (e.g., saving rupees for future use).
3. Unit of Account: Measures value (e.g., prices are quoted in NPR).

Modern Money in Nepal:

• Currency: Coins and banknotes issued by Nepal Rastra Bank (NRB).
• Demand Deposits: Balances in bank accounts (e.g., eSewa wallet, Ncell wallet).
• Near-Money: Assets easily convertible into money (e.g., fixed deposits, bonds).

Types of Money

The Banking System in Nepal

1. Commercial Banks

Functions:

• Accept deposits (savings, current, fixed).
• Grant loans (personal, business, agricultural).
• Facilitate payments (cheques, online transfers via eSewa).
• Provide financial services (forex, insurance, investment).

How Banks Create Money: Banks lend out deposits, creating new money in the economy. For example:

• You deposit ₹10,000 in Global IME.
• The bank keeps ₹1,000 as reserve (required by NRB) and lends ₹9,000 to a business.
• The business deposits the loan in another bank, which lends ₹8,100, and so on.
• Total money created = ₹10,000 / reserve ratio (10%) = ₹100,000.

flowchart TD
    A["Depositor deposits ₹10,000"] --> B["Bank keeps ₹1,000 reserve"]
    B --> C["Lends ₹9,000 to Borrower 1"]
    C --> D["Borrower 1 deposits ₹9,000 in Bank 2"]
    D --> E["Bank 2 keeps ₹900 reserve"]
    E --> F["Lends ₹8,100 to Borrower 2"]
    F --> G["Total money created: ₹100,000"]

Real-World Example: eSewa and Khalti

• These mobile wallets act like demand deposits.
• When you transfer ₹5,000 from your bank to eSewa, it reduces your bank balance but increases liquidity for payments.
• Problem: If too many people withdraw cash simultaneously (a "bank run"), banks may face liquidity crises (as seen in 2020 during COVID-19).

2. Central Bank: Nepal Rastra Bank (NRB)

Functions:

• Issues currency (NPR notes and coins).
• Banker to the government (manages treasury accounts).
• Regulates commercial banks (sets reserve requirements, inspects banks).
• Controls money supply via monetary policy (interest rates, open market operations).
• Acts as lender of last resort (provides emergency loans to banks).

Tools of Monetary Policy:

| Tool               | 2020 Rate/Level | 2023 Rate/Level | Change          |
|--------------------|-----------------|-----------------|-----------------|
| Repo Rate          | 5.5%            | 7.5%            | ↑ Inflation control |
| Reserve Ratio      | 2%              | 3%              | ↑ Liquidity control |
| CRR                | 2%              | 3%              | ↑ Bank stability  |

Inflation: Causes and Effects

Definition

Inflation is a sustained rise in the general price level, reducing purchasing power. Measured by:

• Consumer Price Index (CPI): Basket of goods (food, fuel, housing).
• Wholesale Price Index (WPI): Prices of bulk goods.

Nepal’s Inflation (2018–2023):

graph LR
    A["2018: 4.5%"] --> B["2019: 5.2%"]
    B --> C["2020: 6.1% (COVID impact)"]
    C --> D["2021: 4.8%"]
    D --> E["2022: 7.8% (Highest in 10 years)"]
    E --> F["2023: 6.5%"]

Causes of Inflation in Nepal:

1. Demand-Pull: High demand > supply (e.g., post-lockdown 2021).
2. Cost-Push: Rising production costs (e.g., fuel price hikes by NOC in 2022).
3. Built-in Inflation: Wage-price spiral (workers demand higher pay → firms raise prices).
4. Monetary Factors: Excess money supply (e.g., NRB printing too much currency).

Effects of Inflation:

Year | ₹10,000 Value (Adjusted for Inflation)
2020 | ₹10,000
2021 | ₹9,500
2022 | ₹8,800
2023 | ₹8,200

Deflation: The Opposite Problem

• Definition: Falling price level (e.g., Japan in the 1990s).
• Causes: Excess supply, low demand, technological advances.
• Effects:
  • Consumers delay purchases (waiting for lower prices).
  • Businesses earn less profit → layoffs (e.g., NTC reducing jobs if demand for electricity falls).
  • Debt becomes harder to repay (real value increases).

Nepal’s Deflation Risk:

• If remittances drop (e.g., Gulf workers return), demand for imports (e.g., electronics) may fall → deflation.

How NRB Controls Inflation

1. Monetary Policy Tools (Reviewed)

• Increase repo rate: Banks charge higher interest → less borrowing → less spending → lower demand → lower inflation.
• Raise reserve ratio: Banks lend less → money supply shrinks.
• Sell government bonds: Absorbs excess money from banks.

Example: NRB’s 2022 Response to 7.8% Inflation

• Repo rate hike: From 5.5% → 7.5% (to reduce borrowing).
• Open market operations: Sold ₹20 billion in bonds to absorb liquidity.
• Result: Inflation fell to 6.5% in 2023.

2. Fiscal Policy (Government’s Role)

While monetary policy is NRB’s job, the government uses fiscal policy:

• Increase taxes: Reduces disposable income → lower demand → lower inflation.
• Reduce subsidies: E.g., NOC stopped fuel subsidies in 2022 → higher prices → lower demand.
• Increase public spending: Only if deflation is the problem (e.g., infrastructure projects to boost demand).

Comparison Table: Monetary vs. Fiscal Policy

In the Real World

1. eSewa and Khalti

   • Idea Used: Electronic Money and Demand Deposits
   • How: These wallets hold money in digital form (like demand deposits in banks). When you transfer ₹5,000 from your bank to eSewa, it reduces your bank’s liquidity but increases the money supply in the digital economy. NRB monitors these transactions to prevent money laundering and inflation.

2. Ncell and NTC’s Tariff Hikes

   • Idea Used: Cost-Push Inflation
   • How: When NTC increased electricity tariffs by 20% in 2022, it raised production costs for businesses (e.g., Daraz’s warehouses). These businesses passed on the cost to consumers → general price increase. NRB responded by tightening monetary policy (higher repo rates).

3. Pathao and Daraz’s Loan Dependence

   • Idea Used: Bank Lending and Money Creation
   • How: Pathao and Daraz rely on bank loans for expansion. If NRB increases the repo rate, banks charge higher interest → these companies may struggle to repay loans → slower growth. In 2023, Pathao laid off workers due to high borrowing costs.

4. Nepal’s Remittance-Driven Inflation

   • Idea Used: Demand-Pull Inflation
   • How: When Nepali workers in the Gulf sent ₹1.2 trillion in remittances in 2022, demand for imports (gold, electronics, vehicles) surged. With limited local supply, prices rose → 7.8% inflation. NRB had to act by reducing money supply.

5. Nepal Investment Bank’s Loan Defaults

   • Idea Used: Banking Risks and Liquidity Crises
   • How: In 2020, many borrowers defaulted on loans due to COVID-19. Banks like Nepal Investment Bank faced liquidity shortages. NRB stepped in as the lender of last resort, providing emergency funds to stabilize the system.

Worked Example: Calculating Inflation Impact

Scenario: Your monthly salary was ₹50,000 in 2020. Inflation averaged 6% per year. What is your real salary in 2023?

Solution:

1. Nominal Salary in 2023: ₹50,000 (assuming no raise).
2. Inflation Adjustment:
   • 2020→2021: 6% → ₹50,000 × 1.06 = ₹53,000
   • 2021→2022: 7.8% → ₹53,000 × 1.078 = ₹57,074
   • 2022→2023: 6.5% → ₹57,074 × 1.065 = ₹60,800
3. Real Salary (2023): ₹50,000 / (1.06 × 1.078 × 1.065) ≈ ₹41,300
   • Interpretation: Your ₹50,000 in 2023 buys the same as ₹41,300 in 2020 due to inflation.

| Year | Nominal Salary | Real Salary (2020₹) |
|------|----------------|----------------------|
| 2020 | ₹50,000        | ₹50,000              |
| 2021 | ₹53,000        | ₹50,000              |
| 2022 | ₹57,074        | ₹50,000              |
| 2023 | ₹60,800        | ₹41,300              |

Exam Tip

What Examiners Look For

1. Definitions with Examples:

   • Don’t just write "Inflation is rising prices." Explain why (demand-pull, cost-push) and give a Nepal example (e.g., fuel price hikes by NOC).
   • For money, distinguish between fiat money (NPR), commodity money (gold), and electronic money (eSewa).

2. Diagrams and Graphs:

   • Always draw:
     • Money multiplier process (show deposits, reserves, loans).
     • Inflation trends (use Nepal’s CPI data).
     • NRB’s policy tools (repo rate, reserve ratio changes).
   • Label clearly: E.g., "NRB increases repo rate → Banks raise lending rates → Businesses borrow less → Demand falls → Inflation slows."

3. Real-World Applications:

   • Link theory to Nepal:
     • Monetary policy: "NRB raised the repo rate in 2023 to control inflation caused by remittance-driven demand."
     • Banking: "eSewa acts like a demand deposit; if too many users withdraw cash, it can create a liquidity crisis."
   • Avoid generic examples: Examiners want Nepal-specific cases (Ncell tariffs, Daraz loans, NTC subsidies).

4. Common Mistakes to Avoid:

   • Confusing monetary and fiscal policy:
     • ❌ "Government increases interest rates" → Wrong (NRB does this).
     • ✅ "NRB raises the repo rate to reduce inflation."
   • Ignoring the multiplier effect:
     • ❌ "Banks lend all deposits" → Wrong (they keep reserves).
     • ✅ "With a 10% reserve ratio, ₹10,000 deposit creates ₹100,000 money."
   • Overlooking deflation:
     • Always mention when deflation is worse than inflation (e.g., Japan’s lost decade).

5. Numerical Problems:

   • Practice:
     • Calculating real vs. nominal values (adjust for inflation).
     • Money multiplier: Given reserve ratio, find total money created.
     • Inflation impact: "If prices rise 5% but your salary rises 3%, your real income falls by 2%."
   • Formula to Remember:
     • Real Income = Nominal Income / (1 + Inflation Rate)

Sample Exam Questions and Answers

Question 1: Explain the functions of Nepal Rastra Bank (NRB) with examples. Answer: NRB performs five key functions:

1. Issuer of Currency: Prints and distributes NPR notes/coins (e.g., new ₹1000 note in 2022).
2. Banker to the Government: Manages Nepal’s treasury (e.g., holds funds for the budget).
3. Regulator of Commercial Banks: Sets reserve ratios (e.g., 3% in 2023 to control lending).
4. Controller of Money Supply: Uses repo rate (7.5% in 2023) to fight inflation.
5. Lender of Last Resort: Provided emergency loans to Nepal Investment Bank in 2020 during COVID-19.

Question 2: How does an increase in the reserve ratio affect the economy? Use a numerical example. Answer: If NRB increases the reserve ratio from 5% to 10%:

1. Banks keep more reserves: For every ₹100 deposited, banks must hold ₹10 instead of ₹5.
2. Less lending: Banks lend only ₹90 instead of ₹95 → money supply shrinks.
3. Higher interest rates: Less money available → banks charge more (e.g., loan rates rise from 10% to 12%).
4. Reduced spending: Businesses and consumers borrow less → aggregate demand falls.
5. Lower inflation: Example: In 2022, NRB raised the reserve ratio to 3% to curb 7.8% inflation.

Question 3: Distinguish between demand-pull and cost-push inflation with Nepal examples. Answer:

Final Checklist Before Exam

✅ Memorize:

• NRB’s three main tools: Repo rate, reserve ratio, open market operations.
• 2022–2023 Nepal inflation: 7.8% → 6.5% (due to NRB’s policies).
• Money multiplier formula: $\text{Total Money}=\frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$.

✅ Practice Drawing:

1. Money multiplier flow diagram.
2. Inflation trend graph (2018–2023).
3. NRB’s policy tools table.

✅ Real-World Links:

• eSewa = Electronic money.
• Ncell tariff hikes = Cost-push inflation.
• Daraz loans = Bank lending and money creation.