Money, Inflation and Interest Rates

Money and its functions

Money is anything generally accepted in payment for goods, services and debts. It removes the main problem of barter, the need for a double coincidence of wants.

Kinds of money

• Commodity money: a good with its own use value, such as gold, silver or grain.
• Fiat money: notes and coins with little intrinsic value, accepted because the state declares them legal tender and people trust them. In Nepal, Nepal Rastra Bank (NRB) issues the currency.
• Bank (deposit) money: balances in bank accounts that can be transferred by cheque or electronically.
• Near money: highly liquid assets such as savings and fixed deposits that are not directly spent.

Money supply measures in Nepal

NRB compiles a monetary survey and reports two main aggregates:

• Narrow money (M1) = currency held by the public + demand (current) deposits.
• Broad money (M2) = M1 + time deposits, which in NRB's usage cover savings, call and fixed deposits.

M1 is the most liquid measure. M2 is the aggregate NRB has used as the intermediate target of monetary policy.

Inflation

Inflation is a sustained rise in the general price level, which lowers the purchasing power of money. Deflation is a sustained fall in the general price level. Disinflation is a fall in the rate of inflation while prices still rise. Stagflation is high inflation together with stagnant output and high unemployment.

By cause:

• Demand-pull inflation: aggregate demand exceeds the economy's capacity, for example after rapid growth of money supply or government spending.
• Cost-push inflation: production costs rise, for example higher fuel prices, wages or supply disruptions.

By speed, textbooks distinguish creeping, walking, running (galloping) and hyperinflation.

Who gains and who loses. Unexpected inflation helps borrowers at fixed interest rates and hurts lenders, savers and people on fixed incomes.

Consumer Price Index (CPI)

The CPI tracks the cost of a fixed basket of goods and services bought by households. In Nepal the CPI is compiled and published by NRB.

Inflation rate = (CPI this period - CPI previous period) / CPI previous period x 100

Example: CPI moves from 150 to 159. Inflation = 9 / 150 x 100 = 6 percent.

Per NRB's technical note, the current CPI series uses 2023/24 as its base year (the earlier base year was 2014/15). Its weights come from the fourth Nepal Living Standards Survey (2022/23), with food and beverage at 35.49 percent and non-food and services at 64.51 percent, and prices are collected for 525 items across all 77 districts.

Nominal and real interest rates

The nominal rate is the rate quoted by a bank. The real rate is the nominal rate adjusted for inflation.

• Approximate Fisher relation: real rate = nominal rate - inflation rate.
• Exact relation: (1 + nominal) = (1 + real) x (1 + inflation).

Example 1: deposit rate 9 percent, inflation 6 percent, real rate is about 3 percent.

Example 2: nominal 10.24 percent and inflation 6 percent. Exact real rate = 1.1024 / 1.06 - 1 = 4 percent. The approximation would give 4.24 percent.

If inflation is higher than the nominal rate, the real rate is negative and savers lose purchasing power.

Exam pointers

• Four functions: medium of exchange, unit of account, store of value, standard of deferred payment.
• M1 = currency + demand deposits. M2 = M1 + time deposits (savings, call and fixed).
• Demand-pull comes from excess demand; cost-push comes from higher costs.
• Stagflation = inflation plus stagnation; deflation = falling price level; disinflation = slower inflation.
• Real rate is roughly nominal rate minus inflation.
• NRB compiles Nepal's CPI; base year 2023/24 as per NRB's technical note.