Unit -8: Monetary Theory

Concept of Money Supply

 The money supply is the total amount of money available in an economy at a point of time.
 It includes the total stock of money held by the people and financial institution including the
central bank.
 It refers to currency, printed notes, money in the deposit accounts and in the form of other liquid
assets.
 Money supply is determined by central monetary authority or central bank.
 Money Supply: Flow and Stock
 When money supply is viewed as over a period of time, it is flow concept. Flow of
money supply is measured by multiplying stock of money held by the people and velocity
of circulation of money.
 When money supply is view at a particular time period, it is stock concept. It is the sum
of both cash and deposits available in the country.
 Concepts of Money: Narrow and Broad
 Narrow Money (M1): It is the sum of money supply held by public and demand deposits
held at commercial banks including other deposits held at the central bank.
M1 = C + DD
Where, C = Currency held by Public, DD = Demand deposit held at BFI’s including
deposits of central bank
 Broad Money (M2): It is a sum of narrow money and time deposits. Time deposits
include saving deposits, fixed deposits, call deposits and margin deposits.
M2 = M1 + TD
Where, M1 = Narrow money, TD = Time deposits
Determinants of Money Supply
Money supply is determined by following factors.
 Required Reserve Ratio: The required reserve ratio (or the minimum cash reserve ratio (CRR) or
the reserve deposit ratio) is an important determinant of the money supply. CRR is the certain rate of
amount of the cash that the bank and financial institutions should hold as reserves in the Central Bank.
Nepal Rastra Bank has fixed CRR rate 4% for the commercial banks. If the central bank increases
required reserve ratio, the money supply will be low and vice versa.
 The Level of Bank Reserves: Statutory Liquidity Ratio (SLR) is the portion of total deposits that
financial institutions have to maintain as liquid assets such as cash, government securities and precious
metals. NRB has fixed SLR to be maintained at 10%. Reduction in SLR and CRR frees some funds of
banks and financial institutions for lending and increase money supply.
 Open Market Operation (OMO): It is an activity by a central bank to give or take money to or
from the banks. The central bank can either buy or sell government bonds in the open market. It is also
called repo. The sale of government bonds by central bank decreases money supply and vice versa.
 Public's Desire to Hold Currency and Deposits: If people are in habit of keeping less money with
themselves, they will save more money at banks. The deposits at banks helps to increase credit creation
because the banks can create more money with larger deposits. On the contrary, desire of holding more
currency in hand of people decreases money supply.
 High Power Money (H): Total money issued by the central bank in an economy is a higher power
money or reserve money or monetary base. It is the liability of central bank. High power money is a base
of total money supply in the economy. It is a sum of commercial bank reserve and currency and notes
held by the public. There is direct relationship between stock of high power money and money supply.
H = C + R where, C = Currency held by public and R = Cash held by BFIs
 Money Multiplier (m): Money multiplier is the amount of money that a banking system generates
with each rupees of reserve money. The money multiplier is a ratio of total money supply to stock of high
powered money.
m = M/H
or, M = m.H where, M = Money supply and H = Stock of high power money
The money supply increases with the increase in value of money multiplier and vice versa.

Demand for Money: Keynesian Approach

J.M. Keynes developed a new theory of interest in his book "The General Theory" which is called Liquidity
Preference Theory of Interest". It is also popularly known as Keynesian Theory of Interest or Monetary Theory of
Interest.

Money is the most liquid asset because it can be used immediately as and when required which is not possible with
other assets. People generally have liquidity preference. The liquidity preference means the desire of people to hold
cash money to overcome from unforeseen events. People have strong liquidity preference because they feel
themselves more secure when they hold cash balances. Unless they don't get any reward, they will not part with
liquidity. It means they can be persuaded to give up some part of their cash money if adequate reward is offered.
This reward is paid in the form of interest. Hence, interest is a reward for inducing people to part with liquidity or
cash money. In this way, Keynes belied that interest is paid to the moneylender because he has to part with his liquid
money when he lends his money. Higher the liquidity preference, higher will be the rate of interest paid and vice
versa.

People have liquidity preference or they demand money for the following three reasons or motives. They are:

(i) Transaction motive: The demand for money by individuals and business organization for carrying out day to
day transactions is called demand for liquidity for transaction motive. Individuals hold cash in order to bridge an
interval between receipts of income and its expenditure. Holding money by individuals for this purpose is called the
income motive. Similarly, businessmen also keep some amount of money in ready cash in order to pay for raw
materials, wages, fuels, rent, etc. Holding money by businessmen for this purpose is known as business motive. The
sum of money demand for income motive and business motive is called transaction motive. The transaction motive
for money demand is an increasing function of income.

Lt = f (Y)

Where, Lt = Transaction motive, Y = Level of income

(ii) Precautionary motive: The demand for money by individuals and business organizations to hold cash balances
to safeguard their future against unforeseen contingencies (situation) and emergencies is called demand for liquidity
for precautionary motives. People hold certain amount of money to provide for danger of unemployment, sickness,
accidents and other uncertain events. The precautionary motive for money demand is also an increasing function of
income.

Lp = f (Y)

Where, Lp = Precautionary motive, Y = Level of income

The sum of money demand for transaction and precautionary motive is known as money demand for active cash
balance.

(iii) Speculative motive: The desire of people to keep reserve money to take advantages from the future change in
rate of interest is called demand for liquidity for speculative motive. The money kept by people will be invested in
interest bearing bonds or securities. Bond price and interest rate are inversely related to each other. Given the
expectation about changes in the rate of interest, less money will be held under the speculative motive at a higher
current rate of interest and more money will be held under this motive at a lower current rate of interest. The reason
for this inverse relationship between money held for speculative motive and prevailing interest rate is that people
will lose less by not lending money (i.e. holding money) at a lower interest rate, while they lose more by not lending
at a higher rate of interest. Hence, demand for money under this heading is a decreasing function of interest.

Ls = f (i)

Where, Ls = Speculative motive, i = Level of interest

The sum of money demand for these three motives gives total money demand or liquidity preference. The total
money demand (M) can be calculated as follows.

M = Lt + Lp + Ls

Figure
Money Market and Capital Market
Money Market

Money market is a financial market at which short-term lending or borrowing of fund is made. The short-
term liquid financial instruments are only exchanged in this market. The money market provides loan
facility to the business sectors for less than one year. It helps the business and industries to manage
working capital requirements. Short term securities like treasury bill, travelers’ cheque, ordinary cheque,
draft, promissory notes, bills of payments, inter-bank call money, are traded in this market.
World Bank – “Money market is a place where short term securities such as treasury bills, certificates and
deposits and commercial bills are traded.”
Capital Market
Capital market is a financial market at which medium and long-term lending or borrowing of fund is
made. The money market provides loan facility to the business sectors for more than one year. It helps the
business and industries to manage fund for capital equipment and fixed assets. Long term securities like
bonds, debenture, share, equities, etc. are traded in this market. Capital markets help channelize surplus
funds from savers to institutions which then invest them into productive use. Capital market consists of
primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and
other securities, whereas secondary market deals with the exchange of existing or previously-issued
securities.
World Bank – “Capital market is a place in which long term financial instruments such as equities bonds
are raised and traded.”
Difference between Money and Capital Market

Heading Money Market Capital Market

 Meaning The market which deals with The market which deals with
borrowing and lending of funds borrowing and lending of funds
for short term is called money for medium and long term is
market. called capital market.
Market Nature Money markets are informal in Capital markets are formal in
nature. nature.
Instruments involved Commercial Papers, Treasury Bonds, Debentures, Shares,
Certificate of Deposit, Bills, equities, stocks, etc.
Trade Credit, etc.
Parties involved Commercial banks, non- Stockbrokers, agents, dealers,
financial institutions, central stock exchange, insurance
bank, chit funds etc. companies, Commercial banks,
underwriters etc.
Market Liquidity Money markets are highly Capital markets are
liquid. comparatively less liquid.
Risk Involved Money markets have low risk. Capital markets are riskier in
comparison to money markets.
Maturity of Instruments Instruments mature within a Instruments take longer time to
year. attain maturity
Purpose served To achieve short term credit To achieve long term credit
requirements of the trade. requirements of the trade.
Functions served Increasing liquidity of funds in Stabilizing economy by increase
the economy. in savings
Return on investment achieved ROI is usually low in money ROI is comparatively high in
market. capital market.
Relation with Central Bank Central Bank closely and Central Bank indirectly
directly regulates money market. regulates capital market via
money market.
Monetary Policy

Monetary policy is a policy which is concerned with the change in supply of money, credit and interest
rate. It refers to the policy measures undertaken by the monetary authority or the central bank. The
central bank tries to keep an economy in a state of equilibrium by changing money and credit through
this monetary policy. The monetary policy is used by the central bank to influence the working of the
economic system to achieve specific objectives of full employment, economic growth, price stability, etc.
The monetary policy influences the economic activities through two major variables which are money or
credit supply and interest rate. The monetary policy is also called the Central Bank Policy.

A.J. Shapiro –“Monetary policy is the exercise of the central bank’s control over the money supply as an
instrument for achieving the objectives of general economic policy.”

Types of Monetary Policy

Monetary policy can be expansionary and contractionary.

 Expansionary Monetary Policy: The policy adopted by the central bank to increase money supply
in the economy is expansionary monetary policy. The central bank decreases interest rate or
increases monetary base while adopting expansionary monetary policy. The central bank
decreases cash reserve ratio, decreases bank rate and purchase bonds and securities from open
market to increase money supply in the economy.
  Contractionary Monetary Policy: The policy adopted by the central bank to decrease money
supply in the economy is contractionary monetary policy. The central bank increases interest
rate or decreases monetary base while adopting expansionary monetary policy. The central
bank increases cash reserve ratio, increases bank rate and sells bonds and securities in open
market to decrease money supply in the economy.

Instruments of Monetary Policy

The instruments or tools of monetary policy can be explained by dividing into two types.

a) Quantitative Instruments: They are called general tools of monetary policy.

1. Bank Rate: The rate of interest charged by central bank to commercial banks while providing
loans is called bank rate. The central bank may increase or decrease the bank rate. The fall
in bank rate is called expansionary monetary policy because decrease in bank rate
encourages commercial banks to take more loans from central bank. When they become
able to borrow more funds from central bank at the lower rate, they will be able to supply
more credits to business community at the cheaper rate. This helps to increase the
availability of credit or money supply in the economy. The expansion in credit will increase
investment, output, employment and income.
Bank Rate↓ Loan Taken from Central Bank by BFIs ↑ Credit Creation↑ Interest Rate↓
Bank Rate↑ Loan Taken from Central Bank by BFIs↓ Credit Creation↓ Interest Rate↑

2. Open Market Operation: Sale or purchase of the government securities in money market by
the central bank is called open market operation. The central bank purchases government
securities from commercial banks and public. This helps to increase reserve of the
commercial banks and availability of cash with the general public. The banks lend more and
it leads to increase investment, output and employment in the economy. The purchase of
government securities is called expansionary monetary policy.
Purchase of Govt. Bill/Bonds→ Fund with BFIs and Public↑ Credit Creation↑ Interest
Rate↓
Sell of Govt. Bills/Bonds→ Fund with BFIs and Public↓ Credit Creation↓ Interest Rate↑

3. Change in Reserve Ratio: Every bank is required by law to keep a certain percentage of its
total deposits in the form of a reserve fund at the central bank which is known as cash
reserve ratio. If the central bank decreases cash reserve ratio, the lending capacity of the
commercial banks will increase. It increases investment, employment, income and output in
the economy. The fall in cash reserve ratio is called expansionary monetary policy.
Reserve Ratio↓ Lending Capacity of BFIs ↑ Credit Creation↑ Interest Rate↓
Reserve Ratio↑ Lending Capacity of BFIs ↓ Credit Creation↓ Interest Rate↑

B) Qualitative Instruments: They are called the selective tools of monetary policy.

1. Fixing Margin Requirement: BFIs do not provide loan to the customers as much as the value
full value of collateral. The difference between value of collateral and amount of loan
provided by BFIs is called margin. It is the proportion of collateral amount which is not
financed by the bank. A change in margin implies a change in loan size. This method is used
 to encourage credit supply for the needy sector and discourage it for the other non-
necessary sector. Increase in margin reduces the lending of BFIs against the given collateral
securities and decreases money supply in the economy. The central bank fixes lower margin
requirement for the loans supplied to productive sectors of the economy.
Margin Requirement↓ Lending Capacity of BFIs ↑ Credit Creation↑ Interest Rate↓
Margin Requirement↑ Lending Capacity of BFIs ↓ Credit Creation↓ Interest Rate↑

2. Consumer Credit Regulation: The consumer credit supply is regulated through hire-purchase
and installment sale of consumer goods by the central bank. Under this, change in down
payment amount, installment amount, load duration, etc. are made to expand or contract
credit facilities. It will affect credit creation of the BFIs.
Down Payment or Installment Amount ↓ or Loan Tenure ↑ Credit Creation↑
Down Payment or Installment Amount ↑ or Loan Tenure ↓ Credit Creation↓

3. Publicity: It is another method of credit control. The central bank publishes various reports
stating what is good and what is bad for the economy. This published information can help
public and BFIs to direct them in favor of monetary policy. It helps to divert credit supply in
the desired sectors. The central bank through its weekly and monthly bulletins releases
important credit information to attain goals of monetary policy.
4. Credit Rationing: The central bank fixes credit limit under credit rationing. Credit is rationed
by limiting the amount available for each commercial bank. The central bank may fix the
limit of maximum loans and advances to BFIs or fix ceiling for specific categories of loan and
advances. This can help in lowering banks credit exposure to unwanted sectors.
5. Moral Suasion or Advice: It is a suggestion to commercial banks by the central bank without
any strict action for compliance of the rules. It helps in controlling credit during inflationary
period. Under moral suasion central bank can issue directives, guidelines and suggestions
for BFIs regarding reducing credit supply for speculative purpose.
6. Direct Action: When BFIs do not cooperate with the central bank, the central bank can take
actions against such banks. If certain banks are not adhering to the central bank’s directives,
the central bank may refuse credit supply. It can penalize the commercial banks by charging
some rates. At last it can even put a ban on a particular bank if it does not follow its
directives and work against the objectives of the monetary policy.

Objectives and Significance of Monetary Policy in Developing Countries

The developing counties are entrapped into the various economic problems. The escape from these
problems is essential for rapid economic development and better living standard of people. The
monetary policy helps to rescue the economy from such economic problems and plays significant role to
attain the goals of full employment, rapid economic growth, stable price and exchange rate, favorable
balance of payments, etc. The role of monetary policy can be explained as follows:

(i) Price stability: Price stability is an important objective of monetary policy. The price instability refers
to the situation of inflation and deflation. The inflation and deflation both are harmful for the smooth
operation of an economic system. If price rises very rapidly, it will create uncertainty in business. It will
decrease investment and reduce output and employment. On the other hand, if there is deflation, it will
reduce profit margin. It will decrease investment and reduce output and employment. This type of price
instability is generally created by imbalance between demand for and supply of money. In an economy,
a shortage of money supply will lead to deflation while an excess of it will lead to inflation. The
monetary policy helps to bring a proper adjustment between the demand for and supply of money for
maintaining price stability. The central bank can use different instruments of monetary policy like open
market operation, change in cash reserve ratio, change in bank rate and change in minimum margin
requirement etc. to regulate money supply in the economy.

In Inflation→ Central Bank Uses Contractionary Monetary Policy→ Money Supply↓ Demand↓ Price↓

In Deflation→ Central Bank Uses Expansionary Monetary Policy→ Money Supply↑ Demand↑ Price↑

(ii) Resource mobilization: There is low rate of economic growth in the developing countries because of
deficiency of capital. There are limited resources available in the country and these available resources
are also not properly utilized. The saving and investment are at low levels because of low income of
people. Hence, monetary policy can play an important role to increase the rate of saving and investment
in these countries. The people don’t have an encouragement to save because of lack of banking
institutions in rural areas. The rural people spend larger part of their income in day to day consumption.
Even if some people save some money, there is strong tendency to invest in gold, jewelry, ornaments,
inventories, real estate, etc. rather than in alternative productive channels available in agriculture,
mining, industry, etc. Hence, the effective monetary policy should encourage saving by setting up
banking institutions to expand banking facilities in rural areas. Similarly, attractive interest rate should
be provided on saving to increase the rate of saving. Such effort not only generate saving from rural
sector but also divert investment towards productive sector. Likewise, the central bank should adopt
different measures like cheap interest policy, easy availability of loan with technical support, etc. from
the banking sectors to divert the investment into the productive sector. Such policies will help to
channelize saving from unorganized and unproductive sector to the productive sector for accelerating
the pace of economic development. It will also help to increase national income and employment
opportunities in the country.

(iii) Increasing employment opportunities: The monetary policy has an important role to play in order
to control the problems of unemployment and underemployment. These problems are generally
associated with low investment in agricultural and industrial sectors of the country. So, the central bank
should adopt expansionary monetary policy to increase the supply of money. The increase in money
supply decreases the rate of interest and increase the rate of investment in agriculture and industrial
sectors of the economy. The higher rate of investment in agriculture helps to modernize and
commercialize the agriculture. This will increase employment opportunity in agriculture sector and the
various skilled, semi-skilled and unskilled manpower of the country can get employment in this sector.
Additionally, providing interest subsidized loans to the marginalized section of the society can help to
promote their economic wellbeing and supports to reduce income inequality in the country. Likewise,
the investment in industrial sector will help to establish various medium and large scale industries in the
country. This will also increase employment opportunities in this sector.

(iv) Correction of adverse balance of payment: Balance of payment is a systematic record of all
economic transactions between one country and the rest of the world. It includes the total amount of
visible and invisible items traded during a given period of time. The developing countries always face the
problem of unfavourable balance of payment because they import large quantities of consumption and
capital goods from the foreign countries but they export the agricultural and primary products in limited
quantities abroad. The adverse balance of payment can be corrected with the help of monetary policy.
The central bank should make the policies like devaluation of domestic currency, foreign exchange
control, quota system, etc. to reduce unnecessary imports. Similarly, the exporters should be given
incentives like export subsidy, low interest charge on loan demanded for export oriented industries, etc.
to increase exports.

(v) Controlling trade cycle: The ups and downs in business activities are called trade cycle. The trade
cycle is a common economic problem of modern economies. The trade cycle can be controlled with the
help of monetary policy. In trade cycle, there are phases of expansion and contraction. In expansion, the
economic activities rise very quickly. The income, output, employment, price level, etc. continuously
move upward. The abnormal increase in these economic activities should be controlled. It can be
controlled by contractionary monetary policy. Such policy decreases money supply, increases the rate of
interest and reduces business investment. The decline in investment reduces the abnormal rise in
economic activities and controls upward swings in business activities. Similarly, in contraction the
economic activities should be increased by the central bank by using expansionary monetary policy. The
central bank has to increase money supply to reduce interest rate and encourage business investment.
This will lead to increase economic activities and controls downward swings in business activities. In this
way, the monetary policy helps to control trade cycle and lead the economy in an equilibrium path.

(vi) Increase economic growth: The monetary policy also helps to increase economic growth. The
expansionary monetary policy can be used to achieve high economic growth. The expansionary
monetary policy increases money supply in the economy and decreases rate of interest. The decrease in
rate of interest increases investment in the economy. The increase in investment leads to increase
national income, output and employment of the country and thereby contribute for economic growth.

Exchange Rate

 The currencies of foreign countries is called foreign exchange. Dollar, Euro, Yen, Dirham, etc.
 The rate at which currency of a country exchanged for currency of another country is called
exchanged rate. It shows external purchasing power of domestic currency. USD $1 = NPR 120.
Each US dollar is exchanged for Nepalese currency 120.
 The market where foreign exchange is traded is called foreign exchange market. The foreign
exchange market helps to determine exchange rate in flexible and fixed exchange rate system.

Determination of exchange rate under fixed (pegged) exchanged system

An exchange rate which is predetermined and cannot be changed is called fixed exchange rate. It is
also called pegged exchange rate. It is determined by the government of a country. The central bank
buys and sells its own currency on the foreign exchange market to maintain fixed exchange rate.
Nepal has maintained fixed exchange rate with India. INR 1 = NPR 1.60

The exchange rate is determined in the market by an interaction of demand for and supply of
foreign currency. The process of exchange rate determination has been shown with the help of
following figure.
In the figure, DD curve shows demand for foreign currency suppose US dollar. The DD curve has a
downward slope which implies that more quantity of US dollar is demanded by the local residents
when exchange rate decreases. SS curve shows supply of foreign currency (US dollar). The SS curve
has a downward slope which implies that more quantity of US dollar is supped by the foreigners
when exchange rate increases. The intersection of DD and SS curve determines equilibrium point E
which determines equilibrium quantity of US dollar OQ and exchange rate OR.

If supply of foreign currency decreases, the supply curve will shift parallel leftward to become S1S1
and intersects DD curve at point E1. The equilibrium point E1 determines equilibrium quantity of US
dollar OQ1 and exchange rate OR1 if market in open. It implies that value of US dollar appreciates or
Nepalese currency depreciates. In order to maintain fixed exchange rate and to prevent Nepalese
currency from depreciating, the central bank supplies US dollar from its reserve equal to quantity of
Q1Q level. This helps to make balance between demand and supply of US dollar at initial exchange
rate OR. When foreign exchange rate decreases, the central bank acts in opposite way to avoid
appreciation of domestic currency. In this way, foreign exchange rate is locked in fixed exchanged
system.

Determination of exchange rate under flexible (floating) exchanged system

An exchange rate which is determined by market forces of demand and supply of foreign exchange
is called flexible exchange rate. It is also called floating exchange rate. The central bank does not
intervene in exchange rate determination in the market.

The exchange rate is determined in the market by an interaction of demand for and supply of
foreign currency. The process of exchange rate determination has been shown with the help of
following figure.
In the figure, DD curve shows demand for foreign currency suppose US dollar. The DD curve has a
downward slope which implies that more quantity of US dollar is demanded by the local residents
when exchange rate decreases. SS curve shows supply of foreign currency (US dollar). The SS curve
has a downward slope which implies that more quantity of US dollar is supped by the foreigners
when exchange rate increases. The intersection of DD and SS curve determines equilibrium point E
which determines equilibrium quantity of US dollar OQ and exchange rate OR.

If supply of foreign currency decreases, the supply curve will shift parallel leftward to become S1S1
and intersects DD curve at point E1. The equilibrium point E1 determines equilibrium quantity of US
dollar OQ1 and exchange rate OR1 if market in open. It implies that value of US dollar appreciates or
Nepalese currency depreciates. On the other hand, increase in supply of US dollar decreases
exchange rate and depreciates US dollar and appreciate Nepalese currency. In this way, foreign
exchange rate become upward and downward flexible according to condition of demand and supply
of foreign exchange in the market.