Money and Inflation
Money evolved from barter to overcome its seven difficulties. Modern money serves as a medium of exchange, measure of value, store of value and standard of deferred payment. Fisher's Quantity Theory of Money (MV = PT) links money supply to the price level. Nepal's inflation rate in FY 2080/81 was about 7.9%, controlled by the Nepal Rastra Bank through monetary policy. e-Sewa and Khalti are popular forms of electronic money in Nepal.
In this chapter
Barter System and its Difficulties
Before money was invented, people exchanged goods for goods — this is the barter system. A Terai farmer would trade rice for clothes; a mountain herder would trade chhurpi for salt. The barter system worked in simple small communities, but it faced seven major difficulties that eventually forced humans to invent money.
Seven Difficulties of the Barter System
- Double coincidence of wants — both traders must want exactly what the other has; very rare.
- Lack of common measure of value — how many kg of rice = 1 shirt? No standard ratio.
- Indivisibility — cannot divide a cow into halves to buy small items.
- Difficulty in storing value — rice rots, animals die; many goods are perishable.
- Difficulty in transferring wealth — moving 100 goats to a distant market is costly.
- Difficulty in future payments — hard to write contracts for future exchange.
- Limited market — barter works only locally, not in large markets.
Money — Meaning and Functions
Money is anything that is generally accepted as a medium of exchange and acts as a common measure of value. In Nepal, the Nepali Rupee (रु) is money — a Rs 100 note buys goods because everyone accepts it. The Nepal Rastra Bank (NRB) is the central bank that issues and regulates money in Nepal. The value of money is its purchasing power — how much a rupee can buy. When prices rise, each rupee buys less — money loses value.
Functions of money — primary and secondary
| Type | Function | Explanation | Nepal Example |
|---|---|---|---|
| Primary | Medium of exchange | Money is used to buy and sell goods. | Buying vegetables with Rs 500 note in Kalimati |
| Primary | Measure / unit of value | All goods are priced in money. | A cup of tea = Rs 25 |
| Secondary | Store of value | Money can be saved for future use. | Keeping Rs 1000 in a savings account |
| Secondary | Standard of deferred payment | Future debts are paid in money. | Repaying a bank loan of Rs 50,000 next year |
Forms of Money
- Commodity money — gold, silver, rice, salt (has its own value).
- Metallic money — coins of gold, silver, copper.
- Paper money — notes issued by the central bank (Nepali Rupee notes).
- Credit money — cheques, drafts, credit cards.
- Fiat money — money that has value because the government declares it legal tender (modern notes).
- Electronic / digital money — e-Sewa, Khalti, mobile banking, IME Pay — increasingly popular in Nepal.
Quantity Theory of Money (Fisher's Equation)
Fisher's Quantity Theory of Money — MV = PT
Irving Fisher (an American economist) gave the Quantity Theory of Money. The equation MV = PT says: the total money spent (M × V) equals the total value of goods sold (P × T). If M rises while V and T are constant, P must rise — that is, more money chasing the same goods causes inflation. This is why the Nepal Rastra Bank controls money supply (M2) through monetary policy to keep inflation under control. If NRB prints too much money, prices in Asan and Kalimati will rise. The central bank measures money supply in three aggregates — M1 (narrow), M2 (broad), M3 (broadest):
Money supply measures (M1 narrow → M3 broad)
Inflation — Meaning, Causes, Consequences
Inflation is a sustained rise in the general price level over time. When inflation is 7.9%, a basket of goods that cost Rs 100 last year now costs Rs 107.90. In Nepal, the consumer price index (CPI) is computed by NRB. There are three main causes of inflation: demand-pull (too much money chasing too few goods), cost-push (rising input costs — fuel, wages, raw materials), and imported inflation (when the Indian Rupee strengthens against the US Dollar, Nepal's imports — pegged to INR — become costlier).
Inflation rate from CPI and value of money (purchasing power)
Three main causes of inflation
| Type | Trigger | Nepal Example |
|---|---|---|
| Demand-pull inflation | Aggregate demand rises faster than supply (too much money, too few goods). | Festive-season demand for clothes and electronics during Dashain. |
| Cost-push inflation | Cost of inputs (wages, fuel, raw materials) rises — supply curve shifts left. | Increase in petrol/diesel prices raises transport cost → vegetables and food costlier. |
| Imported inflation | Rise in price of imported goods or depreciation of domestic currency. | When Indian Rupee weakens against US Dollar, Nepal pays more for imports priced in USD. |
Deflation and its Consequences
Deflation is the opposite of inflation — a sustained fall in the general price level. While cheaper goods may seem good, deflation is dangerous: consumers delay purchases expecting lower prices, demand falls, firms cut production and lay off workers, and the economy enters a downward spiral. Consequences of inflation include: (i) loss of purchasing power for fixed-income earners, (ii) creditors lose (debt repaid in cheaper money), (iii) uncertainty reduces investment, (iv) imports rise (foreign goods cheaper relatively). Consequences of deflation include: (i) falling profits, (ii) rising real debt burden, (iii) unemployment rises, (iv) delayed consumption.
Nepal Example — Inflation and Electronic Money
In FY 2080/81, Nepal's average inflation rate was about 7.9%. The Nepal Rastra Bank (NRB) uses monetary policy — controlling money supply (M2), interest rates and reserve requirements — to keep inflation near its target of about 5%. On the money side, e-Sewa, Khalti, IME Pay and mobile banking have made electronic money hugely popular — even small tea-shops in villages accept QR payments. This has sped up the velocity of money (V) and reduced the need to carry cash.
Practice Problem
Using Fisher's equation MV = PT, given: Money supply M = Rs 1000 billion, Velocity V = 4, Price level P = 2 (index), Volume of transactions T = Rs 2000 billion. (a) Verify whether Fisher's identity holds. (b) If money supply rises to Rs 1200 billion while V and T stay constant, find the new price level. (c) Interpret the result.
Practice Problem
Nepal's Consumer Price Index (CPI) was 175 in 2080 BS and 189 in 2081 BS. (a) Calculate the inflation rate for 2081 BS. (b) If a household's nominal income rose by 10% in the same period, did their real income rise or fall, and by how much? (c) If the CPI rises to 205 in 2082 BS, find the inflation rate for 2082 BS.
Quick Revision
- Barter = goods-for-goods; has 7 difficulties (double coincidence, no measure, indivisibility, storage, transfer, future payment, limited market).
- Money = generally accepted medium of exchange; value = purchasing power.
- Primary functions: medium of exchange, measure of value.
- Secondary functions: store of value, standard of deferred payment.
- Forms: commodity, metallic, paper, credit, fiat, electronic.
- Fisher's Quantity Theory: MV = PT — more money, same goods → higher P.
- M1 = Currency + Demand deposits; M2 = M1 + Savings; M3 = M2 + Other deposits.
- Inflation = sustained rise in price level; causes: demand-pull, cost-push, imported.
- Deflation = sustained fall in price level; dangerous — delays consumption, raises real debt.
- Nepal FY 2080/81: inflation ≈ 7.9%; NRB controls money supply.