Monetary Policy: Tools, Transmission, and Real-World Impact

Core Concepts

1. Definition and Objectives

Monetary policy is the process by which a central bank (e.g., Nepal Rastra Bank, NRB) controls the supply of money, availability of credit, and interest rates to achieve macroeconomic stability. Its primary goals are:

• Price stability (controlling inflation/deflation).
• Full employment (reducing unemployment).
• Economic growth (sustaining GDP growth).
• Exchange rate stability (managing currency value, e.g., NPR/USD).

mindmap
  root((Monetary Policy))
    Objectives
      Price Stability
      Full Employment
      Economic Growth
      Exchange Rate Stability
    Tools
      Open Market Operations
      Reserve Requirements
      Interest Rates (Repo Rate, CRR, SLR)
    Transmission Mechanism
      Money Supply → Interest Rates → Investment → Aggregate Demand → GDP

2. Key Tools of Monetary Policy

A. Open Market Operations (OMOs)

Definition: Buying/selling government securities (bonds, T-bills) in the open market to adjust liquidity. How it works:

• Expansionary (loose) policy: NRB buys securities → injects money → lowers interest rates → stimulates borrowing/spending.
• Contractionary (tight) policy: NRB sells securities → absorbs money → raises interest rates → curbs inflation.

Example in Nepal:

• In 2022, NRB sold NPR 50 billion in T-bills to reduce liquidity and control inflation (which hit 8.1% in mid-2022).
• In 2020, NRB bought bonds to inject liquidity during COVID-19 lockdowns.

Source: Nepal Rastra Bank (NRB)

B. Reserve Requirements (CRR & SLR)

Definitions:

• Cash Reserve Ratio (CRR): % of deposits banks must keep as cash with NRB (currently 3% in Nepal).
• Statutory Liquidity Ratio (SLR): % of deposits banks must hold in liquid assets (government securities, gold; currently 8%).

How they work:

• Increase CRR/SLR: Banks have less money to lend → tightens credit → reduces inflation.
• Decrease CRR/SLR: Banks lend more → stimulates economy.

Example:

• In 2021, NRB reduced CRR from 3% to 2% to help banks lend more during the pandemic.
• In 2022, NRB increased SLR to 8% to absorb excess liquidity and curb inflation.

C. Interest Rate Tools

NRB uses repo rate (short-term lending rate to banks) and discount rate to influence borrowing costs.

Example: WhatsApp Pay in Nepal

• When NRB lowers repo rates (e.g., from 6% to 5% in 2023), banks offer cheaper personal loans (e.g., Nabil Bank’s 8% loan vs. Global IME’s 10%).
• This encourages digital payments (like WhatsApp Pay) by reducing transaction costs for merchants.

3. Transmission Mechanism of Monetary Policy

How policy changes affect the real economy:

flowchart TD
  A["NRB Adjusts Tools\n(OMOs, CRR, Repo Rate)"] --> B["Money Supply Changes"]
  B --> C["Interest Rates\n↑/↓"]
  C --> D["Investment & Borrowing\n↑/↓"]
  D --> E["Aggregate Demand\n↑/↓"]
  E --> F["GDP Growth\n↑/↓"]
  F --> G["Inflation/Unemployment\n↓/↑ or ↑/↓"]

Example: Daraz’s Inventory Management

• When NRB cuts repo rates, Daraz’s supplier banks (e.g., Standard Chartered Nepal) offer lower working capital loans.
• This helps Daraz increase inventory during sales (e.g., Daraz Great Days) without high financing costs.

4. Types of Monetary Policy

5. Challenges in Nepal

A. Limited Effectiveness

• High cash economy: ~50% of Nepal’s transactions are cash-based (World Bank, 2022), reducing OMOs’ impact.
• Banking penetration: Only ~50% of adults have bank accounts (vs. ~90% in India), limiting credit transmission.

B. Inflation vs. Growth Trade-off

• 2022 Example: NRB raised repo rate to 6% to control inflation but slowed GDP growth to 2.4% (from 5.8% in 2021).

C. Exchange Rate Pressures

• 2022 Example: High inflation led NRB to defend the NPR by selling USD reserves, depleting foreign exchange (FX) holdings.

## In the Real World

1. Khalti & eSewa (Digital Payments)

   • When NRB lowers transaction fees (e.g., from 1.5% to 1% in 2023), platforms like Khalti reduce merchant costs, boosting adoption.
   • Impact: Khalti’s transactions grew 30% YoY in 2023 (Nepal Rastra Bank data).

2. Nabil Bank’s Loan Rates

   • After NRB cut repo rate to 5% in 2023, Nabil Bank reduced home loan rates from 9% to 7.5%.
   • Result: Home loan demand surged 25% (Nepal Banking Association).

3. Pathao’s Driver Financing

   • Pathao partners with banks (e.g., Global IME) to offer low-interest loans (8–10%) to drivers.
   • When NRB lowers CRR, banks pass on cheaper funds → Pathao can offer longer repayment terms (e.g., 36 months).

## Worked Example: NRB’s 2022 Policy Response

Scenario: Nepal’s inflation hits 8.1% in mid-2022. NRB uses contractionary monetary policy.

Steps:

1. Tool Used: NRB sells NPR 50 billion in T-bills (OMO).
2. Effect:
   • Money supply ↓ → Banks have less liquidity.
   • Repo rate ↑ from 5% to 6%.
3. Impact on Economy:
   • Borrowing costs ↑: Daraz’s supplier loans become expensive → inventory reduces.
   • Inflation ↓: By 2023, inflation falls to 6.8%.
   • GDP growth ↓: From 5.8% (2021) to 2.4% (2022).

Graph:

## Comparison: Monetary vs. Fiscal Policy

## Exam Tip

1. Diagrams are key: Always draw money supply curves (shifted by OMOs) and transmission mechanism flows.
2. Link to real data: Mention NRB’s repo rate changes or inflation figures (e.g., "In 2022, NRB raised repo rate to 6% when inflation was 8.1%").
3. Policy mix questions: Expect questions like:
   • "If unemployment rises, should NRB use expansionary or contractionary policy?" → Expansionary (lower repo rate, buy bonds).
4. Critique limitations: Discuss cash economy, banking penetration, and exchange rate pressures in Nepal.
5. Case studies: Relate to Khalti, Daraz, or Pathao for digital economy impact.