MONETARY POLICY OF NEPAL

A Seminar Paper
By
SONAM SHAH
Bachelor of Business Management
Second Semester
Macroeconomics for Business

Submitted to
The Faculty of Management
MMAMC
Tribhuvan University

NOV, 2023
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INTRODUCTION

Background of the Study

Monetary Policy is taken by the Central Bank to attain broad macroeconomic

objectives of the economy. In another word, Monetary Policy is a set of tools used by
a nation’s central to control the overall money supply and promote economic growth
and employ strategies such as revising interest rates and changing bank reserve
requirements. Gautam Ajay (2020) The NRB is responsible for implementing
Monetary Policy of Nepal and is responsible for maintaining price stability and
promoting economic growth. In the early years of the NRB, Monetary Policy was
mainly focused on controlling inflation and maintaining exchange rate stability.
However, in the 1980s and 1990s, the focus shifted to promoting economic growth
and development. The NRB adopted various Monetary Policy tools, such as open
market operations, CRR and changes in interest rates, to achieve these objectives.

In recent years, Nepal has been facing a number of economic challenges, including
high inflation, low economic growth, and a large trade deficit. The NRB has been
implementing various Monetary Policy measures to address these challenges,
including raising interest rates and tightening credit. Despite these efforts, inflation
remains high and economic growth has been slow. Overall, the study of Monetary
Policy of Nepal has evolved over the years as the country’s economic and political
situation has changed. The NRB continues to play a critical role in promoting
economic stability and growth in Nepal.

Controlling the amount of money in an economy and the channels through which it is
provided is known as monetary policy. Monetary policy strategy is influenced by
economic indicators including the GDP, inflation rate, and industry- and sector-
specific growth rates.

The interest rates that a central bank charges to lend money to the country's banks are
subject to change. Financial institutions modify rates for their clients, such businesses
or homebuyers, as rates rise or fall.
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In addition, it has the power to set foreign exchange rates, purchase or sell
government bonds, and adjust the minimum amount of cash that banks must hold in
reserves. (BROCK, 2023)
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History of Monetary Policy

The history of monetary policy traces back to the establishment of the Bank of
England in 1694, authorized to create gold-backed currency. Central Banks in Europe
adopted the gold standard in the nineteenth century, with the Bank of England taking
on the role of a lender of last resort in the 1870s. This function spread globally,
leading to the establishment of the Federal Reserve in 1913. The abandonment of the
gold standard in the early 20th century allowed Central Banks greater flexibility in
monetary policy. The Great Depression prompted the US to abandon the gold
standard in 1933. The Bretton Woods system followed World War II, pegging
currencies to the US dollar until the early 1970s when ties were severed. The fiat
currency regime emerged, intertwined with theoretical developments like Monetarism
and the introduction of the Taylor rule. The Federal Reserve's switch to a money
supply targeting regime in 1979 helped control inflation. However, the Global
Financial Crisis in 2007/08 challenged conventional approaches, leading to the
decline of the Taylor rule due to the Zero Lower Bound. New policy instruments like
quantitative easing and forward guidance were introduced, redefining how monetary
policy is conducted.

The roots of modern monetary policy can be traced back to the establishment of the
Bank of England in 1694, authorized to issue and maintain gold-backed currency.
Throughout the nineteenth century, Central Banks emerged across Europe, initially
using the gold standard to back their currencies, with roles like the lender of last resort
largely absent. In response to the 1866 crisis, the Bank of England adopted the lender
of last resort function, influencing other Central Banks globally, including the
establishment of the Federal Reserve in 1913. The aftermath of World War I and the
Great Depression led to the abandonment of the gold standard in the 1930s, providing
Central Banks greater flexibility in monetary policy.

Post-World War II, the Bretton Woods system pegged currencies to the US dollar
until the early 1970s when the gold value plummeted, prompting the US to sever ties
between the dollar and gold in 1976, establishing a fiat currency regime. Monetary
policy development intertwined with theoretical advancements, including the rise and
subsequent decline of Monetarism and the introduction of the Taylor rule. The
Federal Reserve's switch to a money supply targeting regime in 1979 helped curb
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inflation, leading to its abandonment in 1993. The New Keynesian Theory, based on
rational optimization, emerged, with the Taylor rule redefining global monetary
policies until the 2007/08 Global Financial Crisis.

The crisis challenged conventional Central Banking approaches, rendering the Taylor
rule less influential due to the Zero Lower Bound. Policy instruments like quantitative
easing and forward guidance were introduced to stabilize the economy, fundamentally
reshaping how monetary policy is conducted.

Introduction.

Monetary Policy, a set of tools employed by a nation's central bank, is crucial for
achieving broad macroeconomic objectives. In Nepal, the NRB is responsible for its
implementation, initially focusing on inflation control and exchange rate stability.
Over time, the emphasis shifted to promoting economic growth and development,
utilizing tools like open market operations and interest rate adjustments. Despite
facing economic challenges such as high inflation, low growth, and a trade deficit, the
NRB strives to address them through measures like raising interest rates. The study of
Nepal's Monetary Policy has evolved, reflecting changes in economic and political
situations, with the NRB playing a vital role in promoting stability and growth.
Monetary policy involves controlling money supply and channels, influenced by
indicators like GDP and inflation rates. Central banks can adjust interest rates,
affecting financial institutions and clients, while also influencing foreign exchange
rates, government bonds, and bank reserve requirements (BROCK, 2023).
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Types of monetary policy

Certainly! Here are explanations for two different types of monetary policy:

1. *Expansionary Monetary Policy:*

- *Objective:* The primary goal of an expansionary monetary policy is to stimulate

economic growth and boost employment.

- *Tools:*

- *Interest Rate Reduction:* Central banks lower interest rates to encourage

borrowing and spending by businesses and consumers. Lower interest rates make
borrowing more attractive and investments more feasible.

- *Open Market Operations:* The central bank purchases financial assets, such as
government bonds, to increase the money supply. This injection of money into the
economy aims to lower interest rates further and stimulate lending.

- *Forward Guidance:* Communicating to the public that interest rates will remain
low for an extended period to influence future expectations and encourage spending
and investment.

2. *Contractionary Monetary Policy:*

- *Objective:* The primary goal of a contractionary monetary policy is to control

inflation and prevent the economy from overheating.

- *Tools:*

- *Interest Rate Increase:* Central banks raise interest rates to make borrowing more
expensive. This discourages spending and investment, which can help cool down an
overheated economy and control inflation.
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- *Open Market Operations:* The central bank sells financial assets, such as
government bonds, to reduce the money supply. This reduction in available money
can lead to higher interest rates, further curbing spending and inflationary pressures.

- *Reserve Requirement Increase:* Central banks may increase the percentage of

deposits that banks are required to hold as reserves. This reduces the amount of
money banks can lend, contributing to tighter monetary conditions.

These two types of monetary policies represent opposite approaches, with

expansionary policies focusing on boosting economic activity and contractionary
policies aiming to rein in inflationary pressures. Central banks often adjust their
policy stance based on the prevailing economic conditions and their objectives for
price stability and sustainable growth.
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Tools of monetary policy

Monetary policy involves the use of various tools by a central bank to control
and regulate the money supply and interest rates in an economy. Here are some
key tools of monetary policy:

1. *Open Market Operations (OMO):*

- *Description:* Central banks buy or sell government securities in the open

market.

- *Effect:* Buying securities injects money into the banking system, promoting
lending and spending. Selling securities withdraws money, reducing lending and
spending.

2. *Interest Rates:*

- *Description:* Central banks set short-term interest rates, such as the federal
funds rate in the United States.

- *Effect:* Lowering rates stimulates borrowing and spending, fostering

economic growth. Raising rates can cool inflationary pressures by reducing
borrowing and spending.

3. *Reserve Requirements:*

- *Description:* Central banks mandate the percentage of deposits that banks

must hold as reserves.
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- *Effect:* Changing reserve requirements influences the amount of money

banks can lend. Lowering requirements boosts lending, while raising them
restricts lending.

4. *Discount Rate:*

- *Description:* The interest rate at which banks can borrow directly from the
central bank.

- *Effect:* Lowering the discount rate encourages banks to borrow more,

promoting lending and economic activity. Raising it has the opposite effect.

5. *Forward Guidance:*

- *Description:* Central banks communicate their future policy intentions to

influence expectations.

- *Effect:* Providing clear guidance on future actions can impact long-term

interest rates and influence spending and investment decisions.

6. *Quantitative Easing (QE):*

- *Description:* Central banks purchase financial assets, usually government

bonds, to increase the money supply.

- *Effect:* Aims to lower long-term interest rates, stimulate investment, and

support economic activity during periods of economic stress.

7. *Currency Interventions:*

- *Description:* Central banks may buy or sell their own currency in foreign
exchange markets to influence its value.
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- *Effect:* Buying currency strengthens it, making exports more expensive and
imports cheaper. Selling currency has the opposite effect.

8. *Inflation Targeting:*

- *Description:* Central banks set explicit inflation targets and adjust policy to
achieve them.

- *Effect:* Provides a clear objective for monetary policy, often enhancing

economic stability.

The combination and emphasis on these tools depend on the economic conditions and
goals of the central bank. Central banks often use a mix of these tools to achieve their
dual objectives of price stability and sustainable economic growth

Qualitative Instrument of Monetary Policy

Change in Lending Margin:

Bank Provide loan to their consumer again collateral but it doesn’t provide full value
collateral. The difference between actual value of collateral and loan provided is
lending margin. Increase in lending margin decrease the credit availability and vice-
versa.

Direct Action
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Direct actions refer the direct instruments issued by the central bank to the
commercial bank regarding investment, credit.

Credit Rationing

This instrument is used to control credit availability and central bank fix the
maximum loan amount.

Moral Suasion

Moral suasion includes requesting, persuading, advising the commercial bank to

cooperate with central Bank for the implementation of Monetary Policy.

Quantities Instruments of Monetary Policy

OMOs

OMOs are the purchase and sale of government securities and treasury bills by the
central bank.
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In case of Inflation, Central bank sells government securities when it decides to

reduce money supply in the economy

In case of deflation, central bank buys government securities when it decides pump
money supply in the economy.

Cash Reserve Ratio(CRR)

CRR refers to the fraction of deposits that BFIs needs to deposit in the central bank.

Bank Rate

It is the interest at which central bank lends credits to the BFIs. It increases the bank
rate that increases the cost of credits to the BFIs and there is credit contraction and
vice-versa.
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Statement of Problem

The Monetary Policy of Nepal encounters challenges primarily due to its

inefficacy in controlling inflation and stabilizing the Nepalese rupee's value.
Issues include a lack of coordination and consistency in implementing measures
between the Central bank and the government. The central bank faces tool
limitations to influence monetary conditions, and the economy's heavy
dependence on foreign remittances and agriculture leaves it vulnerable to
external shocks. Additionally, a significant level of informality in the economy
hinders accurate measurement of economic activity and efficient implementation
of Monetary Policy. Consequently, these factors contribute to the struggle in
controlling inflation and stabilizing the economy, resulting in adverse effects on
the wellbeing of citizens and the overall economic growth of Nepal. To acquire
the knowledge of monetary policy, the questions are developed:

• How is the trend of monetary policy of Nepal?

• What ways to improve the effectiveness of monetary policy?

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Objective of study

1. To analyze the trend of the Monetary Policy of Nepal.

2. To assess the effectiveness of monetary policy in controlling inflation and

stabilizing the currency.

3. To propose measures for improving the effectiveness of monetary policy in

Nepal.
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DISCRIPTION AND DATA ANALYSIS

[11:38 AM, 11/11/2023] SONAM SHAH

Theoretical review

Monetary policy is a crucial tool for stabilizing economies by managing liquidity

and is typically implemented by the country's Central Bank. In developed
economies, this involves adjusting interest rates based on factors such as
inflation and output. Historically, Central Banks used the quantity of money
balance to manage the economy, injecting liquidity during recessions and
absorbing it during economic overheating (Taylor, 1993). While Central Banks
today function similarly, there is a greater emphasis on interest rates over
monetary aggregates.

The choice of target variables, such as monetary aggregates and interest rates, is
determined by the nominal anchor of monetary policy. The Federal Reserve
initially targeted the federal funds rate post-World War II but shifted to
targeting monetary aggregates during the late 1970s crisis. Many developed
economies, influenced by the economic stability achieved, adopted inflation
targeting, while smaller emerging economies like Nepal often use monetary
aggregates or fixed exchange rates (Li and Liu, 2017; Taylor, 2000).
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Taylor (2000) argues that targeting monetary aggregates is more effective than
targeting interest rates in emerging economies. Monetary policies can be
categorized into expansionary and contractionary, addressing economic
conditions. Expansionary policies aim to reduce unemployment and stimulate
economic activities by lowering interest rates or expanding the money supply.
The Zero Lower Bound problem led to unconventional measures like
quantitative easing during the 2007/08 Global Financial Crisis. Conversely,
contractionary policies are implemented during periods of high inflation, raising
interest rates or contracting the money supply to restore economic health
(Bernanke and Mihov, 1998).

The liquidity preference theory, Keynesian skepticism on the effectiveness of

monetary policy in a liquidity trap, and the Monetarist theory emphasizing the
stability of velocity in the quantity theory of money further contribute to the
understanding of monetary policy dynamics (Friedman and Schwartz, 1963;
Schwartz, 2009). The role of monetary policy, its effectiveness, and its impact on
various economic factors continue to be central topics in economic literature.

[11:38 AM, 11/11/2023]SONAM SHAH: Empirical review.

Review on national literature

1. Adhikari, & Shrestha (2015) employed various monetary policy tools,

including open market operations, cash reserve requirements, and interest rate
adjustments, to tackle the challenge of high inflation in Nepal driven by factors
like rising food and fuel prices, supply-side constraints, and a widening trade
deficit.
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2. Dhungana, N.T (2016) conducted an analysis of Nepal's Monetary Policy from

1996 A.D. to 2015 A.D., revealing that open market operations and cash reserve
ratio negatively impact the monetary operation, while the bank rate has a
positive impact on bank lending.

3. Sharma & Mishra (2019) explored the effectiveness of monetary policy in

controlling inflation in Nepal. Their study demonstrated that monetary policy
has a statistically significant impact on inflation, though external factors like
food prices and political instability also contribute. The study further highlighted
that while monetary policy affects interest rates and credit growth significantly,
its transmission to variables like GDP growth is relatively weak.

4. Maharjan, N. (2021) delved into the review of the Monetary Policy of 2077/78
published by the NRB. The study indicated that inflation, particularly in food
items, remained high, but overall inflation decreased due to lower inflation in
non-food items and services. The foreign exchange reserves were found to be in a
favorable position, and measures like reducing interest rates on loans were
implemented to support businesses during the COVID-19 pandemic.

These studies collectively provide insights into the challenges and impacts of
monetary policy in Nepal, addressing issues such as inflation control, interest
rates, and the transmission of policy decisions to the broader economy.


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Review on international literature

1. Fourcans, A. (1978) presented a model of the French financial system and

investigated the influence of monetary policy instruments on one price (interest
rate) and two quantities (stocks of bank credit and money). The study developed
hypotheses regarding the behavior of the banking system and the public, leading
to a theoretical construct of the monetary system. Through comparative static
analysis and empirical testing, it was ascertained that the required reserve
system is not optimally established, suggesting that institutional reforms could
enhance the authorities' control over monetary processes.

2. Angeriz & Arestis (2007) explored the institutional dimension of the Bank of
England's monetary policy and the role assumed by the UK HM Treasury,
grounded in the New Consensus in Macroeconomics (NCM). The inflation
targeting element of monetary policy was based on this theoretical framework.
While the strategy has been successful in keeping UK inflation rates within the
set targets, the paper highlighted and discussed several problematic issues
associated with the policy pursued since 1997.

3. Manpreet Kuar, S. (2020) conducted a study on the evolution of the impact of

Monetary Policy on the Indian economy. The research utilized indicators such as
GDP as a dependent variable and repo rate, unemployment, foreign direct
investment, and inflation as independent variables. The findings indicated that
the Indian economy's well-being is intricately linked to these factors,
emphasizing that the GDP is a composite outcome of various differential
variables influencing the nation's economy.
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These studies collectively provide insights into the impact and effectiveness of
monetary policy in different contexts, addressing issues such as inflation
targeting, institutional dimensions, and the intricate relationship between
monetary instruments and economic variables.
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Data analysis

The main sources of information are published documents, NRB and its published
documents, quartile economic bulletin of Nepal Rastra Bank (NRB).

Data Presentation and Interpretation

The data of Inflation Rate and Interest rate from 2012 A.D to 2021 A.D are presented
and interpreted are listed below:

Table.1
Inflation Rate

Fiscal Year(in AD) Inflation Rate

2012 9.46%
2013 9.04%
2014 8.36%
2015 7.87%
2016 8.79%
2017 3.63%
2018 4.06%
2019 5.57%
2020 5.05%
2021 4.09%
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10.00 %
9.00 %
8.00 %
7.00 %
6.00%
5.00 %
Inflation Rate
4.00%
3.00 %
2.00 %
1.00%
0.00%
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 2 Inflation Rate

The inflation rate from 2012 A.D. to 2021A.D. as given in the table and Figure ranges
from a high of 9.46% in 2012A.D. to a low of 3.63% in 2017 A.D. The rates for the
years 2012-2016 are relatively high, indicating that prices were rising quickly during
that time. In 2015 A.D. & 2016 A.D. due to massive earthquake and blockade done by
neighboring country India which resulted in to high inflation which is 8.79%. This
could be due to factors such as rising costs of goods and services, an increase in
demand, or a decrease in the supply of goods and services. However, the rate drops
significantly in 2017 and remains relatively low through 2021. This suggests that the
rate of price increases slowed during that period. The inflation rate in 2020 is affected
by the COVID-19 pandemic and the oil price crisis.
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Table.2
Interest rate

Fiscal Year (in AD) Interest Rate

2012 6.5%
2013 6.5%
2014 7.5%
2015 9.0%
2016 8.5%
2017 8.0%
2018 7.5%
2019 7.0%
2020 6.5%
2021 7.5%

10
9
8
7
6
5
Interest Rate
4
3
2
1
0
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 3 Interest Rate

In the above table and figure shows the interest rate of Nepal from 2012 to 2021.The
data provided shows the percentage of increase in a certain metric from 2012 to 2021.
In 2012 and 2013, the increase was 6.5%. In 2014, the increase was 7.5%. In 2015,
the increase was 9.0%. In 2016, the increase was 8.5%. In 2017, the increase was
8.0%. In 2018, the increase was 7.5%. In 2019, the increase was 7.0%. In 2020, the
increase was 6.5%. In 2021, the increase was 7.5%.
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CONCLUSION

Conclusion

In conclusion, the study of monetary policy in Nepal reveals several key findings and
challenges. The Monetary Policy of Nepal has evolved over the years, shifting its
focus from controlling inflation and maintaining exchange rate stability to promoting
economic growth and development. However, the effectiveness of monetary policy in
Nepal faces significant hurdles.

One of the major issues is the lack of coordination and consistency in the
implementation of monetary policy measures by the central bank and the government.
This lack of synergy undermines the effectiveness of monetary policy in controlling
inflation and stabilizing the value of the Nepalese rupee. To address this challenge,
there is a need for better communication and collaboration between the central bank
and the government to ensure a coherent and unified approach.

Additionally, the central bank of Nepal has limited tools at its disposal to influence
monetary conditions. The economy is heavily reliant on foreign remittances and
agriculture, making it vulnerable to external shocks. The high level of informality in
the economy further complicates the accurate measurement of economic activity and
the implementation of effective monetary policy. Therefore, there is a need to expand
the range of policy tools and strengthen the capacity of the central bank to respond to
changing economic dynamics.

The study also identifies specific objectives for further analysis. These include
analyzing the trend of monetary policy in Nepal, assessing the effectiveness of
monetary policy in controlling inflation and stabilizing the currency, and proposing
measures to improve the effectiveness of monetary policy. These objectives provide a
roadmap for future research and policymaking in Nepal.

To enhance the effectiveness of monetary policy in Nepal, it is crucial to consider

both qualitative and quantitative instruments. These instruments include interest rate
adjustments, changes in reserve requirements, open market operations, and qualitative
tools such as change in lending margin, direct action, credit rationing, and moral
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suasion. By utilizing a combination of these tools, the central bank can effectively
manage liquidity, control inflation, and promote economic stability.

In conclusion, the study highlights the importance of monetary policy in achieving

macroeconomic objectives and promoting economic stability and growth in Nepal.
Addressing the challenges and improving the effectiveness of monetary policy
requires a collaborative effort between the central bank, the government, and other
relevant stakeholders. By implementing coordinated and consistent measures,
expanding the range of policy tools, and enhancing the capacity of the central bank,
Nepal can strengthen its monetary policy framework and contribute to the overall
development of the economy.
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Angeriz&Arestisthe (2007). Monetary policy in the UK, Cambridge Journal of

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BROCK, T. (2023, March 17). Investopedia . Retrieved from Investopedia.com.

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Fourcans, A. (1978). The impact of monetary and fiscal policies on the French
financial System, Volume 4, Issue 3, August 1978, Pages 519-541

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Approach, History of Monetary Policy of Nepal, Page no. 1

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2077/78

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economy

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