Money & Banking: Money Types, Banks, Central Bank & Nepal’s System

TAKEAWAYS:

• Money is anything accepted as payment, performs 4 functions (medium of exchange, measure of value, store of value, standard of deferred payments).
• Banks create money through credit creation (loans = new money), but the central bank controls this via reserve ratios and open market operations.
• Nepal Rastra Bank (NRB) is Nepal’s central bank—it issues currency, controls inflation, and regulates commercial banks.
• Commercial banks earn profit by lending deposits, while central banks focus on monetary policy (interest rates, money supply).
• Near money (savings deposits, bonds) is not liquid like cash but can be converted easily.
• Inflation and deflation are caused by too much or too little money in circulation—NRB uses tools like repo rate and open market operations to fix them.

What is Money?

Money is anything that people accept as payment for goods and services. It makes trade easier than barter (exchanging goods directly). In Nepal, we use rupees as money, but money can also take other forms.

Functions of Money

Money has four main functions:

1. Medium of Exchange: Used to buy and sell goods (e.g., paying ₹100 for a notebook).
2. Measure of Value: Helps compare prices (e.g., a pen costs ₹50, a book costs ₹300).
3. Store of Value: Can be saved for future use (e.g., keeping cash in a bank).
4. Standard of Deferred Payments: Used for loans and future payments (e.g., taking a bank loan).

graph TD
    A["Money"] --> B["Medium of Exchange"]
    A --> C["Measure of Value"]
    A --> D["Store of Value"]
    A --> E["Standard of Deferred Payments"]

Types of Money

Money can be classified into three types:

1. Commodity Money: Has value on its own (e.g., gold, silver coins).
2. Fiat Money: Has value because the government says it is legal tender (e.g., Nepalese rupee notes).
3. Near Money: Not liquid but can be converted into cash (e.g., savings deposits, bonds).

Example:

• Commodity Money: In ancient times, people used gold coins to buy goods.
• Fiat Money: Today, we use ₹100 notes printed by Nepal Rastra Bank (NRB).
• Near Money: If you keep ₹5,000 in a savings account, it is not cash but can be withdrawn anytime.

What are Banks?

Banks are financial institutions that accept deposits and give loans. They play a key role in the economy by:

• Helping people save money safely.
• Providing loans for businesses and individuals.
• Creating money through credit creation.

Types of Banks

There are two main types:

1. Commercial Banks (e.g., NMB Bank, Global IME Bank)

   • Function: Accept deposits, give loans, and earn profit.
   • How they make money: Charge interest on loans (higher than deposit interest).
   • Example: If you deposit ₹10,000 in NMB Bank, they may lend ₹8,000 to a business and earn interest.

2. Central Bank (Nepal Rastra Bank - NRB)

   • Function: Controls money supply, issues currency, and regulates commercial banks.
   • How it works: Sets interest rates, controls inflation, and manages foreign exchange.
   • Example: NRB decides the repo rate (interest rate for short-term loans to banks).

How Do Banks Create Money?

Banks create money when they give loans. This is called credit creation.

How It Works (Step-by-Step)

1. Initial Deposit: Suppose you deposit ₹1,000 in a bank.
2. Bank Keeps Reserves: The bank keeps 10% (₹100) as reserve (as per NRB rules) and lends ₹900 to a farmer.
3. Farmer Spends Loan: The farmer buys seeds worth ₹900, and the shopkeeper deposits this ₹900 in the same bank.
4. New Deposit: Now, the bank has ₹1,900 (₹1,000 + ₹900).
5. Bank Lends Again: It keeps ₹190 as reserve and lends ₹1,710 to a trader.
6. Money Multiplies: This process continues, creating more money in the economy.

Total Money Created = Initial Deposit × (1 / Reserve Ratio) = ₹1,000 × (1 / 0.10) = ₹10,000

flowchart TD
    A["You deposit ₹1,000"] --> B["Bank keeps ₹100, lends ₹900"]
    B --> C["Farmer spends ₹900"]
    C --> D["Shopkeeper deposits ₹900"]
    D --> E["Bank now has ₹1,900"]
    E --> F["Bank keeps ₹190, lends ₹1,710"]
    F --> G["Money grows to ₹10,000"]

Key Point:

• The reserve ratio (set by NRB) controls how much money banks can create.
• If NRB lowers the reserve ratio, banks can lend more → more money in economy.
• If NRB raises the reserve ratio, banks lend less → less money in economy.

Role of Nepal Rastra Bank (NRB)

Nepal Rastra Bank (NRB) is Nepal’s central bank. Its main functions are:

1. Issuing Currency

• Prints and supplies rupee notes and coins.
• Controls counterfeit money to keep the economy safe.

2. Banker to the Government

• Manages government accounts (e.g., pays salaries, collects taxes).
• Helps the government borrow money by selling government bonds.

3. Controller of Credit

• Sets interest rates (e.g., repo rate, discount rate).
• Regulates commercial banks to prevent fraud.

4. Custodian of Foreign Exchange

• Manages Nepal’s foreign currency reserves (e.g., USD, EUR).
• Controls exchange rates (e.g., how many rupees = 1 USD).

5. Monetary Policy Tools

NRB uses these tools to control inflation (rising prices) and deflation (falling prices):

Example:

• If inflation is high (prices rising too fast), NRB may:
  • Increase repo rate → Banks lend less → Less money → Prices stabilize.
• If economic growth is slow, NRB may:
  • Decrease repo rate → Banks lend more → More money → Businesses grow.

Problems in Banking System

Even though banks are useful, they can face problems:

1. Bank Runs

• When many depositors withdraw money at once, the bank may not have enough cash.
• Example: In 2023, some small banks in Nepal faced runs when people lost trust.

2. Inflation & Deflation

• Inflation: Too much money → Prices rise (e.g., ₹100 buys less than before).
• Deflation: Too little money → Prices fall (bad for businesses).

3. Bad Loans (NPAs - Non-Performing Assets)

• When borrowers fail to repay loans, banks lose money.
• Example: A factory takes a loan but closes → bank loses that money.

4. Counterfeit Money

• Fake notes disrupt the economy and hurt honest businesses.
• NRB’s Role: Uses security features (watermarks, holograms) to prevent fakes.

Money and Banking in Nepal

Nepal’s banking system includes:

• Commercial Banks (e.g., NMB, Standard Chartered, Global IME).
• Development Banks (e.g., Agricultural Development Bank).
• Finance Companies (e.g., Finance One, Siddhartha Finance).
• Microfinance Institutions (e.g., SEWA, Finca).

Recent Trends in Nepal

1. Digital Banking: More people use mobile banking (eSewa, Khalti).
2. Foreign Exchange: NRB controls how much rupees can be exchanged for USD/EUR.
3. Inflation Control: NRB raises interest rates when inflation is high.

Example:

• In 2022, Nepal’s inflation was 8.5% (high due to global oil price rise).
• NRB increased repo rate to 7.5% to control it.

Solved Examples

Example 1: Credit Creation

If a bank has a 10% reserve ratio and you deposit ₹5,000, how much money can the bank create?

Solution:

1. Initial deposit = ₹5,000
2. Reserve ratio = 10% → Reserve = ₹500
3. Money created = Deposit × (1 / Reserve Ratio) = ₹5,000 × (1 / 0.10) = ₹50,000

Answer: The bank can create ₹50,000 in total.

Example 2: Effect of Repo Rate

If NRB increases the repo rate from 6% to 8%, what happens?

Solution:

• Higher repo rate → Banks borrow more expensive from NRB → Lend less to public → Less money in economy → Inflation decreases.

Answer: Inflation will fall because banks lend less.

NEB Board-Style Questions

Short Answer Questions

1. Define money. Explain its four functions. (Answer: See "Functions of Money" section above.)

2. What is the difference between commercial banks and central banks? (Answer: See comparison table above.)

3. How does credit creation work? Explain with an example. (Answer: See "How Do Banks Create Money?" section.)

4. What are the tools used by Nepal Rastra Bank to control inflation? (Answer: See "Monetary Policy Tools" table.)

5. What is a bank run? How can it be prevented? (Answer: See "Bank Runs" section + NRB supervision.)

Long Answer Questions

6. Explain the functions of Nepal Rastra Bank. How does it control inflation? (Answer: Cover all 5 functions + monetary policy tools like repo rate, CRR, open market operations.)

7. What is credit creation? How much money can a bank create if the reserve ratio is 20% and initial deposit is ₹20,000? (Answer: ₹100,000; show calculation step-by-step.)

8. Discuss the problems faced by the banking system in Nepal. How can they be solved? (Answer: Bank runs, NPAs, inflation → Solutions: NRB regulations, digital banking, public trust.)

Exam Tip

✅ For NEB exams, focus on:

• Definitions (money, bank, NRB, repo rate, CRR).
• Diagrams (credit creation, monetary policy tools).
• Numerical problems (credit creation calculations).
• Real-world examples (NRB’s role in inflation control).
• Comparison tables (commercial vs. central bank).

❌ Avoid:

• Memorizing too many terms without understanding.
• Skipping calculations (always show steps).
• Forgetting to link theory with Nepal’s economy.

Good Luck! 🚀 (Remember: Practice past NEB questions to understand the exam pattern.)