Monetary Policy: An Introduction

Adarsha Subedi / Kathmandu: Monetary policy is the demand side economic policy that is undertaken by the central bank of a country to control the money supply to achieve macroeconomic goals for economic growth.

Monetary policy consists of the operations of drafting and implementing the plans of actions taken by the central bank to control the quantity of money and the supply of new money in the economy. Monetary policy uses the money supply and interest rate to influence aggregate demand, credit, rate of inflation, growth of the economy, and the liquidity of money. These can be achieved by the change in interest rate, buying and selling of government bonds, and changing the amount of money to behold by the bank as reserves.

Monetary policy is formed by the central bank by gathering inputs from different sectors of the economy. There are sources like the GDP, inflation, growth rate of specific industrial sectors, and international markets. Monetary authorities have simple policy goals, to achieve a stable rise in the gross domestic product of the country, maintain low rates of unemployment, and maintain foreign exchange rate and inflation rate in a good range. It can be used as complementary to fiscal policy. The fiscal policy consists of tax and government spending to influence the economy.

Types of Monetary policies.

Monetary policy can be classified as expansionary and contractionary policies.

Expansionary monetary policy occurs when the interest rates are lowered and the money supply is increased. For instance, if a country is facing a high unemployment rate during the recession, the country can use monetary policy to increase aggregate demand and for the expansion of the economy. Expansionary policy lowers the interest rate to lower the saving and increase the spending. There is an increase in the money supply in the country which increases the spending and investment. When demand increases more need to be supplied thus, the unemployment rate decreases.

Contractionary monetary policy occurs when the interest rate is increased and the money supply is decreased. For instance, the increase in money supply can lead to high inflation, raising the cost of living, and doing business. It can increase the interest rate prompting the increase in saving which slows the growth of money supply in the market. This decreases aggregate demand and lowers inflation. This can slow the economic growth and increase the unemployment rate but is required to control inflation.

Implementing Monetary policy

Monetary policy can be implemented by buying and selling government bonds. The central bank buys bonds from other banks or directly from the government using freshly created money. This process is called open market operations. When the money supply increases the interest rate lowers until the targeted interest rate is met. Injecting more money in the economy by the central bank by buying government bonds and other financial assets is also called quantitative easing.

Second, monetary authorities can change the interest rate and the collateral required while a bank takes a loan from the central bank. If higher interest rates are charged and requiring higher collateral the banks will not make any risky investments or be extra cautious while lending the money, this is contractionary monetary policy. If the lending to the banks is at lower rates with lower collateral requirements the banks will make riskier and bold investments, this is expansionary monetary policy.

Another way of monetary policy implementation is the change in the reserve requirements. The reserves are the funds that a bank must retain as a proportion of the deposits made by the customers to ensure that they meet their liabilities. Lowering the reserve required by the banks increased the money supply in the economy. The bank could offer more loans and increase their investments. Increasing the reserve requirements decreased bank lending and slowed the growth of the money supply in the economy.

Some features of the monetary policies of Nepal 2019/20

The monetary policy stance for 2019/20 has been designed taking into account the current situation of the economy, domestic and global economic outlook, the Fifteenth Plan, and the annual budget of the GoN for 2019/20.

An increase in public and private investment is likely to boost up aggregate demand. Monetary policy will focus on maintaining monetary aggregates at the desired level to avert the inflationary pressure originating from the demand side.

Monetary policy will focus on interest rate stability through effective liquidity management.

Focus on containing price inflation within 6 percentage for maintaining price stability. Monetary management will be carried out to facilitate the economic growth of around 8.5 percent as targeted by the annual budget of the GoN.

The nominal GDP has been taken as the basis for monetary projection. Given this, the limit for the growth of broad money (M2) has been set at 18 percent.

Some features of the monetary policies of Nepal 2020/21

Monetary Policy emphasizes to help the Government of Nepal to achieve its economic growth goals while maintaining macroeconomic stability. Monetary policy has targeted to keep the inflation within 7% Growth of Private Sector Credit and the Broad Money Supply (M2) is aimed to limit at 20 % and 18 % respectively.

Keeping economic recovery at priority, the monetary policy aims to maintain liquidity to help to achieve the goal of economic growth.

The monetary policies of Nepal focus more on growth and development by increasing spending and investment. The economists are trying to focus on the expansionary monetary policy to take the country from developing to a middle-income country. Especially, the monetary policy 2020/21 has an expansionary policy because the economy is at a recession due to the COVID-19 pandemic. The economic growth was down to 2.27% from 7.05% compared to the previous year. Several studies have shown that the world economic growth rate at the end of 2020 may reach -6% which will bring down the already depressed economy. Hence, monetary policy should focus on investment, credit, employment generation to boost up the suffered economy for the stable economic condition of the country.

(Editor’s Note: Mr. Adarsha Subedi is undergraduate student at Kathmandu University School of Arts. Mr. Subedi has keen interest on economics, finances and policy making. Nepalekhabar has been promoting creative ideas and write up of young people. How do you find this article, please share your comment at : info@nepalekhabar.com)