Monetary Policy

Concept / Term
Monetary Policy
Branch
Macroeconomics
Definition & Explanation

Monetary Policy

Monetary policy refers to the strategic actions undertaken by a central bank to manage the money supply and credit conditions in an economy. Its primary goal is to influence interest rates and achieve macroeconomic objectives such as controlling inflation, fostering sustainable economic growth, ensuring full employment, and stabilizing exchange rates.

Authority in Nepal

  • Nepal Rastra Bank (NRB): Established in 1956 as the central bank of Nepal, the NRB is solely responsible for formulating, implementing, and monitoring monetary policy in the country.

Key Tools of Monetary Policy

Central banks use a range of tools to influence the money supply and credit conditions:

  1. Bank Rate (Policy Rate / Repo Rate): This is the interest rate at which the central bank lends money to commercial banks (usually for short-term needs). A higher bank rate discourages borrowing by commercial banks, thereby reducing the money supply and credit availability in the economy.
  2. Open Market Operations (OMO): This involves the buying and selling of government securities (such as treasury bills and bonds) in the open market by the central bank.
    • Buying securities: The central bank injects money into the banking system, increasing bank reserves and the money supply (expansionary).
    • Selling securities: The central bank drains money from the banking system, reducing bank reserves and the money supply (contractionary).
  3. Cash Reserve Ratio (CRR): This is the percentage of a commercial bank's total deposits that it is legally required to hold as reserves with the central bank. A higher CRR reduces the amount of funds banks have available to lend, thereby contracting the money supply.
  4. Statutory Liquidity Ratio (SLR): This is the percentage of a bank's total deposits that it must maintain in the form of liquid assets, such as cash, gold, or approved government securities, within its own vaults. A higher SLR reduces the bank's ability to lend.

Types of Monetary Policy

  • Expansionary (Loose) Monetary Policy: Implemented during economic slowdowns or recessions. It involves lowering interest rates, decreasing reserve requirements, and buying government securities to increase the money supply and credit availability. The goal is to stimulate aggregate demand, investment, and employment.
  • Contractionary (Tight) Monetary Policy: Implemented to combat inflation and cool down an overheating economy. It involves raising interest rates, increasing reserve requirements, and selling government securities to reduce the money supply and credit availability. The goal is to curb aggregate demand and inflationary pressures.

Nepal's Context and Challenges

  • The NRB's primary objectives include maintaining price stability, fostering a sound financial system, and supporting sustainable economic growth.
  • Nepal's monetary policy is significantly influenced and often constrained by its pegged exchange rate with the Indian Rupee. This peg limits the NRB's independence in setting interest rates, as its policy decisions must often align with those of the Reserve Bank of India to maintain the peg.

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