Monetary Theory
- Monetary theory examines the role of money in the economy. This unit covers the concept and determinants of money supply
- the Keynesian approach to the demand for money
- money and capital markets
- monetary policy (concept, types, objectives, and instruments)
- the determination of equilibrium exchange rates under fixed and flexible exchange rate systems.
In this chapter
Money Supply: Concept and Determinants
- Money supply is the total stock of money circulating in the economy at a given time. It includes currency (notes and coins) held by the public and demand deposits (checking accounts) in banks. Economists measure money supply in different aggregates: M1 = currency + demand deposits (most liquid)
- M2 = M1 + savings deposits + time deposits
- M3 = M2 + other liquid assets. In Nepal, Nepal Rastra Bank (NRB) publishes these aggregates. The money supply multiplier shows how an initial deposit creates a larger total money supply through the banking system's lending process.
Money supply and the money multiplier
Money Supply Aggregates in Nepal (illustrative)
| Aggregate | Components | Approx. Value (Rs billion) |
|---|---|---|
| M1 (Narrow money) | Currency + demand deposits | 800 |
| M2 (Broad money) | M1 + savings + time deposits | 4,500 |
| Reserve money (MB) | Currency in circulation + bank reserves | 600 |
Demand for Money: Keynesian Approach
- Transactions motive — to make day-to-day purchases; money demand is proportional to income (L1 = kY)
- Precautionary motive — to cover unforeseen emergencies; also proportional to income
- Speculative motive — to take advantage of future changes in interest rates and bond prices; inversely related to the interest rate (L2 = f(r), with L2 falling as r rises). Total money demand: L = L1(Y) + L2(r) = kY − hr. The money demand curve slopes downward in (r, M) space
Keynesian money demand (liquidity preference)
Money Market and Capital Market
The money market deals with short-term borrowing and lending (less than one year) — Treasury bills, commercial paper, call money. It provides liquidity for short-term needs. The capital market deals with long-term financing (more than one year) — stocks (shares), bonds, debentures, and long-term loans. It funds investment in plant, equipment, and infrastructure. Together, they form the financial market. In Nepal, the Nepal Stock Exchange (NEPSE) is the main capital market institution; the money market is operated by NRB and commercial banks through Treasury bills and interbank lending.
Monetary Policy
Monetary policy is the process by which the central bank (Nepal Rastra Bank in Nepal) manages the money supply and interest rates to achieve macroeconomic objectives — price stability, full employment, economic growth, and balance of payments equilibrium. Expansionary monetary policy increases money supply and lowers interest rates to stimulate the economy (used during recessions). Contractionary monetary policy reduces money supply and raises interest rates to fight inflation (used during booms).
Instruments of Monetary Policy
- Open Market Operations (OMO) — the central bank buys or sells government securities. Buying injects money (expansionary); selling withdraws money (contractionary).
- Bank Rate (Policy Rate) — the interest rate at which the central bank lends to commercial banks. Raising it makes bank borrowing expensive, reducing money supply; lowering it does the reverse.
- Cash Reserve Ratio (CRR) — the fraction of deposits banks must keep as reserves at the central bank. Raising CRR reduces banks' lending capacity; lowering it expands lending.
- Statutory Liquidity Ratio (SLR) — the fraction of deposits banks must keep in liquid assets (cash, gold, government securities).
- Moral suasion — the central bank persuades banks to follow its policy direction through meetings, letters, and public statements.
- Credit rationing — the central bank directly limits the amount banks can lend.
Exchange Rate Determination
The exchange rate is the price of one currency in terms of another. Under a fixed exchange rate system, the central bank pegs the currency to another currency (e.g., the US dollar) or to a basket. The central bank buys or sells foreign currency to maintain the peg. Under a flexible (floating) exchange rate system, the exchange rate is determined by the supply and demand for currencies in the foreign exchange market. Nepal follows a pegged exchange rate system — the Nepali rupee is pegged to the Indian rupee at a fixed rate (NPR 1.60 = INR 1), while it floats against other currencies like the US dollar.
Real-Life Example: Nepal's Exchange Rate
Nepal pegs the Nepali rupee to the Indian rupee at NPR 1.60 = INR 1 (fixed since 1993). This peg is maintained because India is Nepal's largest trading partner (about 60% of trade). Against the US dollar, the rupee floats — in 2023, it was about NPR 132 per USD, up from about NPR 100 in 2015. The depreciation against the dollar makes imports (especially petroleum) more expensive, contributing to inflation. Nepal Rastra Bank manages foreign exchange reserves (about $10–12 billion in 2023) to maintain the peg and ensure import cover for at least 7 months.
Practice Problem
Nepal Rastra Bank wants to increase the money supply by Rs 50 billion. The currency-deposit ratio (c) is 0.2 and the reserve-deposit ratio (r) is 0.15. (a) Calculate the money multiplier. (b) How much should NRB increase the monetary base (through open market operations) to achieve the Rs 50 billion increase in money supply? (c) Should NRB buy or sell government securities?
Functions and Types of Money
- Medium of exchange — facilitates trade without barter
- Unit of account — measures and compares value
- Store of value — allows purchasing power to be saved for future use
- Standard of deferred payment — enables lending and borrowing. The types of money have evolved: commodity money (gold, silver — has intrinsic value), representative money (paper backed by gold), fiat money (paper with no intrinsic value, accepted by government decree — all modern currencies), and increasingly electronic/digital money (credit cards, mobile wallets like eSewa, Khalti in Nepal, and cryptocurrencies)
Quantity Theory of Money
The Quantity Theory of Money (QTM), developed by Irving Fisher (1911), states that the general price level is proportional to the money supply. The Fisher equation: MV = PY, where M = money supply, V = velocity of money (how many times a rupee changes hands per year), P = price level, Y = real output. If V and Y are constant (classical assumptions), then P is proportional to M — doubling M doubles P. The Cambridge version (Marshall, Pigou): M = kPY, where k is the fraction of income people hold as money (k = 1/V). The QTM implies that inflation is always and everywhere a monetary phenomenon (Friedman) — sustained inflation requires money supply growth.
Quantity theory of money — Fisher and Cambridge versions
Instruments of Monetary Policy
| Instrument | Expansionary (↑M) | Contractionary (↓M) |
|---|---|---|
| Open Market Operations | Buy government securities | Sell government securities |
| Bank rate / Policy rate | Lower the rate | Raise the rate |
| Cash Reserve Ratio (CRR) | Lower CRR | Raise CRR |
| Statutory Liquidity Ratio (SLR) | Lower SLR | Raise SLR |
| Moral suasion | Encourage lending | Restrict lending |
Real-Life Example: Nepal's Digital Payment Revolution
Nepal has seen rapid growth in digital money. Mobile wallets like eSewa, Khalti, and IME Pay now handle billions of rupees in transactions monthly. QR code payments are common in urban shops. The Nepal Rastra Bank has launched NepalPay and supports ConnectIPS for interbank transfers. This shift reduces the need for physical cash (lower currency-deposit ratio), which affects the money multiplier. Digital payments also improve tax collection (electronic trails) and financial inclusion — reaching rural areas where bank branches are scarce. However, cyber security and digital literacy remain challenges.
Key Terms and Definitions
- Money supply (M): Total stock of money in the economy — मुद्रा आपूर्ति: अर्थतन्त्रमा कुल मुद्रा स्टक।
- M1: Currency + demand deposits (most liquid) — M1: मुद्रा + माग निक्षा।
- M2: M1 + savings + time deposits (broad money) — M2: M1 + बचत + समय निक्षा।
- Money multiplier: m = (1+c)/(c+r) — how base money creates broad money — मुद्रा गुणक।
- Velocity of money (V): How many times a rupee changes hands per year — मुद्राको गति।
- Quantity theory: MV = PY — price level proportional to money supply — मात्रा सिद्धान्त।
- Liquidity preference: Keynes's money demand (3 motives) — तरलता प्राथमिकता।
- Monetary policy: Central bank management of money supply and interest rates — मौद्रिक नीति।
- Open Market Operations: Central bank buys/sells government securities — ओपन मार्केट अपरेसन।
- Bank rate: Interest rate at which central bank lends to commercial banks — बैंक दर।
- CRR: Fraction of deposits banks must keep as reserves — नगद आरक्षण अनुपात।
- Exchange rate: Price of one currency in terms of another — विनिमय दर।