What is Monetary Policy?
Monetary policy refers to the set of actions and strategies implemented by the Nepal Rastra Bank (NRB), the central bank of Nepal, to regulate the money supply, credit, and interest rates in the economy.
Thank you for reading this post, don't forget to subscribe!- The main aim is to achieve economic stability, control inflation, encourage investment, and support sustainable economic growth.
In Nepal, the monetary policy is announced annually by the Nepal Rastra Bank in line with the government’s fiscal policy to ensure coordination between monetary and fiscal measures.
Objectives of Monetary Policy
The main objective of monetary policy is to promote sustainable economic growth of the country. For the fulfillment of main objectives, the monetary policy involves the following objectives:
- Price Stability
- Exchange Rate Stability
- Financial Stability
- Economic Growth
1. Price Stability
Price stability is one of the most important objectives of monetary policy. It aims to maintain inflation at a moderate and predictable level so that the value of money remains stable over time. Stable prices protect consumers’ purchasing power, reduce uncertainty in the economy, and encourage savings and investments. By controlling inflation, the central bank helps create a stable economic environment necessary for long-term growth.
2. Exchange Rate Stability
Exchange rate stability refers to keeping the value of the domestic currency stable against foreign currencies. A stable exchange rate helps promote international trade, attract foreign investment, and maintain confidence in the economy. Sudden fluctuations in exchange rates can cause trade deficits, increase import costs, and create economic uncertainty. Through monetary policy tools, the central bank works to prevent excessive volatility in the exchange rate.
3. Financial Stability
Financial stability means ensuring the smooth functioning of financial institutions and markets. Monetary policy aims to prevent banking crises, control excessive credit growth, and maintain trust in the financial system. When financial markets are stable, businesses can borrow easily, households can save safely, and the economy can operate without disruption. Therefore, maintaining financial stability is essential for economic progress and risk reduction.
4. Economic Growth
Monetary policy also aims to support sustainable economic growth by ensuring adequate credit availability and stable financial conditions. By influencing interest rates and money supply, the central bank encourages investment, production, and employment. A stable economic environment created by proper monetary policies leads to higher output, increased income levels, and overall economic development.
Instruments of Monetary Policy
Monetary policy instruments are the tools used by the central bank (such as Nepal Rastra Bank) to control the supply of money, influence interest rates, and stabilize the economy. The major instruments of monetary policy are explained below:
- Interest Rate Adjustment
- Change Receive Requirements
- Open Market Operations (OMO)
- Credit Guidence
- Collateral Policy
1. Interest Rate Adjustment
Interest rate adjustment refers to the central bank’s action of increasing or decreasing key policy rates such as the bank rate, repo rate, and reverse repo rate.
- When the central bank raises interest rates, borrowing becomes expensive, credit demand decreases, and inflation falls.
- When it lowers interest rates, borrowing becomes cheaper, investment increases, and economic activities expand.
Interest rate adjustments help control inflation, maintain liquidity, and influence overall economic growth.
2. Change in Reserve Requirements
Reserve requirement means the percentage of deposits that commercial banks must keep with the central bank and cannot use for lending.
- If the central bank increases the reserve ratio, banks have less money to lend, reducing the money supply.
- If it decreases the reserve ratio, banks can lend more, increasing money supply and stimulating the economy.
Changing reserve requirements is a powerful tool because it directly affects the lending capacity of banks.
3. Open Market Operations (OMO)
Open Market Operations refer to the buying and selling of government securities (like treasury bills) in the financial market by the central bank.
- When the central bank sells securities, money flows out of the banking system, reducing liquidity.
- When it buys securities, money enters the banking system, increasing liquidity.
OMO is used to manage short-term interest rates, control inflation, and maintain financial stability.
4. Credit Guidance
Credit guidance means the central bank gives instructions or directions to commercial banks regarding how credit should be allocated.
This may include:
- restricting loans in risky or unproductive sectors,
- encouraging credit flow to priority sectors like agriculture, SME, hydropower, and exports,
- limiting excessive credit expansion in certain industries.
Credit guidance ensures that credit is distributed in line with national economic priorities and avoids imbalance in the economy.
5. Collateral Policy
Collateral policy refers to the rules set by the central bank regarding the types of assets banks can use as collateral when borrowing from the central bank.
- The central bank decides which securities qualify as acceptable collateral and at what value (haircut).
- A strict collateral policy limits risky borrowing, while a flexible policy increases liquidity options for banks.
This tool helps maintain financial discipline, control risk in the banking sector, and support stable credit flow during financial stress.
Importance of Monetary Policy in Nepal
- Controls Inflation and Ensures Stability:
Helps maintain stable prices, preventing economic fluctuations. - Encourages Investment:
By regulating interest rates, it promotes borrowing for productive purposes. - Supports Employment Generation:
By stimulating industrial and business activities, it helps create job opportunities. - Balances Trade Deficit:
Helps manage imports and exports through foreign exchange stability. - Ensures Financial Discipline:
Strengthens the banking system and maintains public trust in financial institutions. - Promotes Economic Development:
Encourages lending to priority and productive sectors to achieve inclusive economic growth.