MONETARY POLICY IN NEPAL

A Seminar Paper
By Ishika Khadka
Bachelor of Business Administration (BBA)
2 nd Semester Macroeconomics for Business
Submitted to Faculty of Management Bhaktapur Multiple Campus Tribhuvan University
Jestha, 2080
 1. Introduction
1 Background
Monetary policy is one the most important microeconomic policy in Nepal. The policy issued
by the central bank of the country to achieve specific microeconomic activities through a
change in the money supply and rate of interest are called monetary policy.
As per the Nepal Rastra Bank Act, 2002, the major objective of this bank is to formulate and
then implement monetary and exchange rate policy to achieve price and balance payment
stability for economic stability and sustainable economic development. Accordingly, the bank
has been formulating and publicly announcing monetary policy since 2002/03. In addition,
the bank has started a half-yearly review of the policy since 2003/04, and a quarterly review
since 2016/17 to make necessary changes in policy measures after reviewing the economic
and financial situation.
As per the Colloquium at the National Bank of Belgium Brussels(2010) There exists a whole
library on the history of central banking and monetary policy in the 20th century (see e.
Capie et al., 1994). As a devotee to the law of comparative advantage, in this paper I will try
to provide the reflections of somebody who, coming from academia with a special interest in
monetary economics, played a special role in two central banks under extremely demanding
circumstances: In the Bundesbank as member of the Executive Board and chief economist
from 1990 to 1998 in the aftermath of German reunification in 1990 and the preparation for
European Monetary Union (EMU); In the European Central Bank as member of the
Executive Board and chief economist from the start in 1998 to 2006. In both institutions it
was a challenge and a privilege to build a bridge between research and policy.
According to Warin (2005), "monetary policy is the process of overseeing a nation's money
supply to complete specific objectives such as restraining inflation, or achieving full
employment, which usually involve setting interest rates, margin requirements, cash reserve
ratio, reserve requirement, capitalization standards for banks and non-banking institutions
(insurance firms), and acting as the lender of last resort".
economic growth. If monetary policy is too restrictive, it may curtail economic activity,
leading to stagnation or recession. Conversely, if it is too accommodative, it may fuel
inflationary pressures that erode purchasing power and disrupt market equilibrium. Another
issue arises from the globalized nature of economies, where monetary policy decisions in one
country can have spill-over effects on others, making coordination and cooperation essential
but challenging to achieve. Furthermore, the effectiveness of monetary policy may be
hindered by structural impediments, such as high levels of public debt or limited transmission
mechanisms within the financial system. Lastly, the rapid advancements in technology,
changing financial landscapes, and unconventional monetary tools present policymakers with
the challenge of adapting and staying ahead to ensure the effectiveness and relevance of
monetary policy in a rapidly evolving economic environment. Addressing these complexities
requires careful analysis, nimble decision-making, and constant evaluation of the monetary
 policy framework to navigate the ever-changing dynamics of the global economy. Therefore,
the seminar paper tries to answer the questions:
i. What is the theoretical perspective of monetary policy?
ii. What is the practice of monetary policy in Nepal?
1 Objectives
The objectives of the seminar paper are as follows:
i. To review the theoretical perspective of monetary policy.
ii. To review the monetary policy practice in Nepal.
1 Methods
To fulfill the objectives of the seminar paper, the literature review approaches of study is
used. To study regarding the theoretical as well as empirical perspective of monetary policy
practice in Nepal, the books, research articles and journals are reviewed and analyzed them to
draw the conclusion of seminar paper.
2. Description and Analysis
2 Theoretical review
Various theories on monetary policy are as follows:
Monetary policy is an essential program of action undertaken by the monetary authority,
generally thecentral bank, to control and regulate the supply of money and the flow of credit
with a view to achieving predetermining microeconomic goals.
Monetary policy is a critical tool used by central banks to achieve macroeconomic stability
by influencing the supply and demand for money and credit in an economy. In Nepal, the
Nepal Rastra Bank (NRB) is responsible for formulating and implementing monetary policy.
This section provides a theoretical review of the monetary policy framework in Nepal.
Monetary policy is referred to as either being an expanison policy , or a contractionary
policy, where an expansionary policy increases the total supply of money in the economy
,and a contractionary policy decreases the total money supply. Expansionary policy is
traditionally used to combat unemployment in a recession by lowering interest rates, while
contractionary policy involves raising interest rates inorder to combat inflation. Monetary
policy is contrasted with fiscal policy , which refers to government borrowing, spending and
taxation. Credit policy is not only a policy concerned with changes in the supply of credit but
it can be and is much more than this. Credit is not merely a matter of aggregate supply, but
becomes more important factor since there is also issue of its allocation among competing
users.
Several studiesexplain the relationship between monetary and other macroeconomic
variables. Monetary policy target variables like monetary aggregates and interest rates are
determined by the nominal anchor of the monetary policy. In the period after the second
world war, the Federal Reserve targeted federal funds rate to conduct monetary policy. The
crisis of the late 1970s exposed this approach to monetary policy, so the Federal Reserve
switched to targeting monetary aggregates to pull the economy out of the crisis. The
 monetary policy carried out by the Federal Reserve in the aftermath of the crisis resembled
inflation targeting regime (Taylor, 1993); in fact, the relation postulated in Taylor (1993) held
until the Global Financial Crisis of 2007/08. This result, alongwith the remarkable economic
stability in the aftermath of the crisis of the late 1970s provided an impetus for many
developed and rapidly developing economies to switch to inflation targeting. This trend has
continued to the present day. The case of underdeveloped andsmall Emerging economies is
quite different. These economies mostly use either monetary aggregates or fixed exchange
investment and consumption are little affected by interest rates - as Hansen and many of
Keynes' other American disciples came to believe - lower interest rates, even if they could be
achieved, would do little good. Monetary policy is twice damned. The contraction, set in
train, on this view, by a collapse of investment or by a shortage of investment opportunities or
by stubborn thriftiness, could not, it was argued, have been stopped by monetary measures.
But there was available an alternative - fiscal policy. Government spending could make up
for insufficient private investment. Tax reductions could undermine stubborn thriftiness.
2 Empirical Review
Empirical research on monetary policy in Nepal is relatively limited. However, some studies
have examined the effectiveness of monetary policy tools and their impact on the economy.
The following is a brief overview of some of the empirical research on monetary policy in
Nepal:
1 of Interest Rate Transmission Mechanism: A study by the Nepal Rastra Bank,
the central bank of Nepal, examined the effectiveness of the interest rate transmission
mechanism in Nepal. The study found that the transmission of policy rates to lending rates
was weak, with only a partial pass-through of policy rates to lending rates. This suggests that
changes in policy rates may not have a significant impact on borrowing costs for businesses
and individuals.
2 of Monetary Policy on Economic Growth: A study by Bhattarai and Tamang (2019)
examined the impact of monetary policy on economic growth in Nepal. The study found that
monetary policy had a positive and significant impact on economic growth, indicating that
the central bank's efforts to maintain price stability and promote economic growth were
effective.
3 Rate Dynamics: A study by Bhattarai and Sharma (2017) examined the exchange
rate dynamics in Nepal and the effectiveness of the central bank's intervention in the foreign
exchange market. The study found that the exchange rate in Nepal was largely determined by
external factors, such as the exchange rateof the US dollar and India's rupee. The study also
found that the central bank's intervention in the foreign exchange market was ineffective in
stabilizing the exchange rate.
4 Stability: A study by Bhattarai and Sharma (2019) examined the impact of
monetary policy on financial stability in Nepal. The study found that monetary policy had a
 significant impact on financial stability, with changes in policy rates affecting the profitability
and stability of banks and other financial institutions. The study suggestedthat the central
bank should consider the impact of its monetary policy decisions on financial stability when
making policy decisions.
Empirical research on monetary policy in Nepal is limited, but the available studies suggest
that monetary policy has a significant impact on the economy, including economic growth
and financial stability research is needed to understand the effectiveness of monetary
policy in Nepal and to identify strategies to improve its effectiveness.
2 Monetary policy Practices in Nepalese Context
Ajay Gautam (2020) tested that monetary policy contributes to stabilize the economy in many respects. As such,
there is a practice instating suitable monetary policy going back to the time of the great depression. Since then,
monetary policy has become one of the intense area to research and study by the economists. Theories like
monetarism and New Keynesianism were developed to understand the monetary dynamics and formulate robust
monetary policies. Over the past 30 years, New Keynesian theory has been used to understand and formulate new
monetary policies with great success. Until recent years, applications of these theories were mostly confined to
developed economies. Lately, there have been a substantial number of studies attempting to understand monetary
policy using these frameworks in the setting of emerging economies. This thesis is a continuation of that effort inthe
Nepalese context. Here, I develop a New Keynesian framework to study and identify the features of Nepalese
monetary policy using the data for the period of 2002/03 to 2014/15. In particular, I compare three different monetary
policy rules to find out which one best represents Nepalese monetary policy, as carried out by Nepal Rastra Bank. I
find that Nepalese monetary policy largely resembles Friedman’s k-percent rule, and Taylor rule is an improper model
for Nepalese monetary policy. Using this setup, this thesis presents the analysis on the importance of exogenous
shocks. The finding of this analysis suggests that Nepalese business cycle is primarily driven by monetary policy
shocks and supply shocks. I also find significant level of price rigidity, investment adjustment costs and habit
formation in consumption in Nepalese economy. In regards to optimal monetary policy, I find that a policy regime that
aggressively targets inflation along with fixed money growth rate maximizes aggregate household welfare, thus is an
optimal policy.
Nischal Dhungel(2023) The Nepal Rastra Bank (NRB), the central bank of Nepal, took an
accommodating policy stance during the pandemic to support households and businesses.
The average inflation rate in fiscal year (FY) 2020/21 stood at 3 percent and doubled to
6 percent in FY 2021/22. For the first six months of the current FY 2022/23, it stands at
7 percent. Inflation has significantly increased due to the detrimental effect of the supply
chain post-Covid19 pandemic and the Russia-Ukraine war. Rising inflation raised the cost of
fuel and raw materials, causing production costs to skyrocket. As a result, the output
capacities of both small and large-scale industries have decreased. The
2 Analysis of data in Nepal
Nepal Rastra Bank (NRB) released the monetary policy for the FY 2022/23 keeping in mind the current
macroeconomic scenario of the economy. Keeping in mind the lockdown imposed by the pandemic, the previous two
monetary policies were expansionary in nature targeted for economic recovery by promoting consumption and
production. However, due to the liberal nature of monetary policy and increasing price of petroleum products,
inflationsurged from 4% at the beginning of the fiscal year (mid-August 2021) up to 8% towards to end of the previous
fiscal year (mid-June 2022).In the same period, credit expansion by Banks and FinancialInstitutions (BFIs) increased
imports leading to surge in the trade deficit, causing woes for policy maker Nepal, the most important categories in
the consumer price index are food and beverages (44 percent of the total weight) and housing and utilities (20
percent). The index also includes education (7 percent); clothing and footwear (7 percent); transport ( percent);
furnishings and housing equipment (4 percent); health (3 percent); communication (3 percent); miscellaneous goods
and services (3 percent) and recreation and culture ( percent).
Figure 1
Trend of Inflation
 Source: Monetary Policy 2022/23, Nepal Rastra Bank
In the above figure, we can clearly see that the inflation of Nepal in the fiscal year 2020/21 is 3%. and in the
beginning of fiscal year 2021/22(mid-august,2021) inflation rate is 4% and it ended as 8% at the end of fiscal year
2021/22 (mid-june,2022).The trade deficitincreased by 25% to NPR 1577 billion (USD 12 billion) which led to
deterioration in the forex reserveto NPR 1176 billion (USD 9 billion). Such a level of forex reserve can finance imports
for less than 6-months while the NRB has set the target to maintain forex reserve to sustain 7-months of imports the
deteriorating macroeconomic indicators which posed a threat to the stability of the domestic economy, the central
bank has adopted a contractionary monetary policy. Such stance has been adopted to control the unstable economy
fueled by a huge surge in imports-based consumption and the effect of the ongoing war between Russia and Ukraine.
Therefore, the stance of the monetary policy has been cautiously tightened with the objective “to promote
macroeconomic stability while maintaining price and external sector stability, and to support economic growth through
increasing productivity by channelizing financial resources to productive sectors”.Such stance has been adopted to
achieve the government’s economic growth target of 8%and inflation target of 7% for the FY 2022/23.
Figure 2
Trend on interest rate corridor
Source: Monetary policy 2022-2023,Nepal Rastra Bank
The interbank rate remained high and on par with an upper limit of the interest rate corridor, i., bank rake, reflecting
excessive pressure on domestic liquidity in the banking system.
NRB has made provision to intervene via Open Market Operation (OMO) only if interbank interest rate fluctuates by
more than 2% of the targeted policy rate (repo rate). Similarly, NRB
2. Policy Targets: The Nepal Rastra Bank (NRB) set the policy targets of maintaining foreign exchange reserves
covering seven months of imports and limiting inflation to 7 percent for the fiscal year.
3. Credit and Money Supply: The NRB aimed to restrict total credit to the private sector by 12 percent and total money
supply by 12 percent for FY 2022/23.
4. Cash Reserve Ratio (CRR): The NRB raised the cash reserve ratio from 3 percent to 4 percent as part of its
monetary policy measures.
5. Credit Expansion and Inflation Concerns: Due to faster-than-expected credit expansion, growing imports, declining
reserves, and rising inflation, the NRB increased interest rates to curb inflation and discourage credit lending.
6. Interest Rates: The interest rates for inter-bank lending and lending to borrowers increased significantly between
January 2021 and January 2022.
7. Credit Constraint: Despite additional liquidity injections, private sector credit returned to the previous year's
levels due to higher lending interest rates offered by commercial banks.
8. Liquidity Injections: The NRB injected a total of Rs3094 billion in liquidity until mid-January 2023 through various
measures, such as repo, outright buy auction, and standing liquidity facility (SLF).
9. Merger and Acquisition Policy: The NRB introduced a policy to promote mergers and acquisitions among financial
institutions to strengthen financial stability, resulting in a decrease in the number of commercial banks and micro-
finance institutions.
10. Credit Allocation: A significant portion of the outstanding credit held by banks and financial institutions went to the real
estate sector, followed by current assets.
Overall, the monetary policy for FY 2022/23 focused on maintaining stability, addressing inflation concerns, and
promoting financial sector consolidation through mergers and acquisitions. The NRB implemented measures to
manage credit expansion, increase liquidity, and regulate interest rates to achieve its policy objectives.
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