Chapter 4: Money, Banking, and Credit Creation
Money is the lifeblood of any modern economy. Understanding what money is, how banks create it, and how the central bank controls its supply is essential for understanding macroeconomic policy. This chapter covers the functions of money, the banking system, the money creation process through credit multiplication, and Nepal Rastra Bank's role in monetary management.
4.1 Money: Definition and Functions
Definition: Money is anything generally accepted as a medium of exchange, a measure of value, a store of value, and a standard of deferred payments. In Nepal, the legal tender is the Nepali Rupee (NPR), issued by Nepal Rastra Bank.
Functions of Money
| Function | Type | Description | Example |
|---|---|---|---|
| Medium of Exchange | Primary | Eliminates barter; enables buying and selling | Using NPR to buy goods at a shop in Kathmandu |
| Measure of Value | Primary | Common unit to express prices of all goods | Rice priced at NPR 80/kg, not in terms of other goods |
| Store of Value | Secondary | Preserves purchasing power over time | Saving NPR in bank for future use |
| Standard of Deferred Payment | Secondary | Facilitates credit transactions and future payments | Bank loan repayment in monthly NPR installments |
| Transfer of Value | Contingent | Enables value transfer across locations | Remittance from Qatar to Nepal in NPR |
Types of Money
| Type | Description | Nepal Example |
|---|---|---|
| Commodity Money | Money with intrinsic value (gold, silver) | Historical use of silver coins in Nepal |
| Fiat Money | Government-declared legal tender with no intrinsic value | NPR notes and coins (current system) |
| Bank Money | Demand deposits in banks (checkable deposits) | Savings and current account balances |
| Digital Money | Electronic forms of money | eSewa, Khalti, mobile banking balances |
4.2 Money Supply
Money supply is the total stock of money in circulation in the economy at a given point in time. Nepal Rastra Bank measures money supply using different aggregates.
Money Supply Measures
| Measure | Components | Liquidity | Also Called |
|---|---|---|---|
| M1 (Narrow Money) | Currency in circulation + Demand deposits | Highest | Transaction money |
| M2 (Broad Money) | M1 + Time deposits + Savings deposits | Lower | Total money supply |
4.3 Banking System
Structure of Nepal's Banking System
| Level | Institution | Role | Examples |
|---|---|---|---|
| Central Bank | Nepal Rastra Bank (NRB) | Monetary policy, bank regulation, currency issue, lender of last resort | NRB (established 1956) |
| Class A | Commercial Banks | Accept deposits, provide loans, payment services | Nabil Bank, NIC Asia, Nepal Bank Ltd |
| Class B | Development Banks | Medium/long-term lending for development | Nepal Infrastructure Bank |
| Class C | Finance Companies | Consumer lending, hire purchase | Various finance companies |
| Class D | Microfinance Institutions | Small loans to low-income groups | Nirdhan Utthan, Chhimek Laghubitta |
4.4 Credit Creation by Commercial Banks
Credit creation is the process by which commercial banks multiply deposits through lending. When a bank receives a deposit, it keeps a fraction as reserves (required by NRB) and lends out the rest. The borrower's spending becomes someone else's deposit, which is again partially lent out, creating a chain of deposits.
Credit Multiplier Formula
Total Deposit Creation = Initial Deposit × (1/CRR)
Credit Multiplier = 1/CRR
Credit Creation Process (Example)
Given: Initial deposit = NPR 10,000, CRR = 20%
| Round | Bank | Deposit | Reserve (20%) | Loan |
|---|---|---|---|---|
| 1 | Bank A | 10,000 | 2,000 | 8,000 |
| 2 | Bank B | 8,000 | 1,600 | 6,400 |
| 3 | Bank C | 6,400 | 1,280 | 5,120 |
| 4 | Bank D | 5,120 | 1,024 | 4,096 |
| ... | ... | ... | ... | ... |
| Total | 50,000 | 10,000 | 40,000 |
Total deposits = 10,000 × (1/0.2) = NPR 50,000
Credit multiplier = 1/0.2 = 5
Total credit created = 50,000 - 10,000 = NPR 40,000
Limitations of Credit Creation
| Limitation | Explanation |
|---|---|
| Cash Leakage | If people hold cash instead of depositing, the chain breaks |
| Excess Reserves | Banks may hold reserves above required minimum during uncertainty |
| Lack of Borrowers | If creditworthy borrowers are scarce, banks cannot lend |
| NRB Regulations | Sector-wise lending limits, capital adequacy requirements |
| Economic Conditions | Recession reduces loan demand; boom increases it |
4.5 Quantity Theory of Money
The Quantity Theory of Money establishes the relationship between money supply and price level. It exists in two forms:
Fisher's Equation of Exchange
MV = PT (or MV = PY in modern form)
Where: M = Money supply, V = Velocity of circulation (how many times each unit of money is spent per year), P = General price level, T = Volume of transactions (or Y = real output)
| Assumption | Classical View | Keynesian Critique |
|---|---|---|
| V is constant | V determined by institutional factors, changes slowly | V is variable, especially in short run; changes with interest rates |
| T/Y is fixed at full employment | Economy always at full employment; output cannot change | Economy can be below full employment; output can increase |
| M determines P | Increase in M only raises P proportionally | Increase in M may raise Y (output) instead of or in addition to P |
Numerical Example:
If M = NPR 500 billion, V = 4, P = 200 (price index), Y = 10 billion units
MV = PY → 500 × 4 = 200 × 10 → 2,000 = 2,000 ✓
If M increases to 600 billion (20% increase) and V, Y constant:
600 × 4 = P × 10 → P = 240 (20% increase in price level = 20% inflation)
Implication: If NRB increases money supply by 20%, and velocity and output remain constant, inflation will also be 20%. This is the core classical argument against excessive money creation.
Cambridge Cash Balance Equation (Marshall-Pigou)
Md = kPY where k = 1/V (fraction of income people want to hold as cash)
At equilibrium: Ms = Md = kPY. This provides the same conclusion as Fisher but from a demand perspective — people's desire to hold money determines the price level.
4.6 Nepal Rastra Bank — Functions in Detail
| Function | Description | How NRB Implements It |
|---|---|---|
| Currency Issue | Sole authority to issue currency notes and coins | Prints notes at Banknote Printing Press, Janakpur; manages currency in circulation |
| Banker to Government | Manages government accounts, issues treasury bills | Conducts government securities auctions; manages public debt |
| Banker's Bank | Holds reserves of commercial banks; provides lending facility | Banks maintain CRR deposits at NRB; NRB provides refinance and standing liquidity facility |
| Lender of Last Resort | Provides emergency liquidity to banks in distress | Bank rate lending; emergency liquidity assistance during crises |
| Foreign Exchange Management | Manages forex reserves; maintains NPR-INR peg | Buys/sells foreign currency; maintains ~7+ months import cover |
| Banking Regulation | Licenses, regulates, supervises all banks | Capital adequacy norms (11%+), NPA classification, merger directives, fit and proper test for promoters |
| Financial Inclusion | Expand access to financial services | Branchless banking policy, deprived sector lending (5%), financial literacy programs |
4.7 Credit Creation — Extended Example with Multiple Scenarios
Scenario Comparison: Impact of Different CRR on Credit Creation
Initial Deposit = NPR 1,00,000
| CRR | Credit Multiplier | Total Deposits | Total Credit Created | Total Reserves |
|---|---|---|---|---|
| 5% | 20 | 20,00,000 | 19,00,000 | 1,00,000 |
| 10% | 10 | 10,00,000 | 9,00,000 | 1,00,000 |
| 20% | 5 | 5,00,000 | 4,00,000 | 1,00,000 |
| 25% | 4 | 4,00,000 | 3,00,000 | 1,00,000 |
| 50% | 2 | 2,00,000 | 1,00,000 | 1,00,000 |
Key Observations: (1) Lower CRR → more credit creation → potentially more economic growth but also more inflation risk. (2) Total reserves always equal the initial deposit — reserves are never destroyed, only redistributed. (3) NRB can powerfully control money supply by adjusting CRR — even a 1% change in CRR for Nepal's banking system affects billions of rupees in lending capacity.
4.8 Digital Money and Financial Technology in Nepal
| Platform | Type | Services | Users (Approx.) |
|---|---|---|---|
| eSewa | Digital wallet | Bill payment, transfers, QR payments, merchant payments | 15+ million |
| Khalti | Digital wallet | Similar to eSewa + ticketing, investment | 10+ million |
| ConnectIPS | Interbank payment | Bank-to-bank transfers, bill payments | Growing rapidly |
| Mobile Banking | Bank apps | Full banking services via smartphone | Most bank customers |
| QR Payments | Merchant payments | Scan-and-pay at shops, restaurants | Widespread in urban areas |
Impact on Money Supply: Digital money affects velocity of circulation (V increases as transactions become faster and more frequent). It also helps NRB track financial flows better and may reduce the informal economy's size over time. NRB has been exploring Central Bank Digital Currency (CBDC) possibilities following global trends.
Practice Questions
Short Answer:
1. What are the functions of money? Explain primary and secondary functions.
2. Differentiate between M1 and M2 money supply.
3. Explain the credit creation process with an example.
4. What is the credit multiplier? Derive its formula.
5. Describe the structure of Nepal's banking system.
Long Answer:
6. "Money is what money does." Discuss the functions of money with examples from Nepal. (15 marks)
7. A bank receives an initial deposit of NPR 100,000. If CRR is 10%, show the credit creation process for 5 rounds and calculate total deposits, total reserves, and total credit created. (15 marks)
8. Explain the process of credit creation by commercial banks. What factors limit credit creation? Apply to Nepal's banking context. (15 marks)
9. Discuss the role of Nepal Rastra Bank as the central bank of Nepal. How does it regulate the banking system? (15 marks)
10. "Digital money is transforming banking in Nepal." Discuss the evolution of money from commodity to digital with reference to Nepal's payment systems. (15 marks)
Exam Tips: ✓ Credit creation numerical is almost always asked — practice thoroughly ✓ Know credit multiplier formula: 1/CRR ✓ Show complete round-by-round process ✓ Distinguish M1 and M2 clearly ✓ Reference NRB and Nepal's banking classes