Macroeconomics: banking system and monetary policy

Expansionary monetary policy is a policy adopted by the central bank to increase the money supply and lower interest rates in order to boost aggregate demand, investment, and output during deflation or recession.

Under the Bank and Financial Institutions Act (BAFIA), 2073, the Nepal Rastra Bank (NRB) licenses and supervises banks and financial institutions (BFIs) in Nepal. They are classified as follows.

1. Central bank The Nepal Rastra Bank, established in 2013 BS (1956 AD), is the apex bank. It issues currency, formulates and implements monetary policy, acts as banker, adviser and lender of last resort to the government and to banks, supervises all BFIs and manages foreign exchange reserves.

2. Commercial banks (Class "A") These are licensed for all types of banking business: accepting deposits, lending, remittance, foreign exchange, letters of credit and other services. Examples: Nabil Bank, Nepal Investment Mega Bank, Rastriya Banijya Bank, Agricultural Development Bank.

3. Development banks (Class "B") They provide medium- and long-term finance for industry, agriculture, infrastructure and other development activities, and may work at national or provincial level. Examples: Muktinath Bikas Bank, Garima Bikas Bank.

4. Finance companies (Class "C") They mainly provide hire-purchase, leasing, housing and consumer loans and term finance. They cannot accept current account deposits. Examples: Pokhara Finance, Guheshwori Merchant Banking and Finance.

5. Microfinance financial institutions (Class "D") They give small loans, mostly through group lending, to low-income and rural households, especially women, to support self-employment. Examples: Nirdhan Utthan Laghubitta, Chhimek Laghubitta.

6. Other licensed institutions Cooperative banks, infrastructure development banks and payment service providers (such as eSewa and Khalti) operate under NRB or related regulation with limited functions.

Thus Nepal has a hierarchical system, with the central bank at the top and A, B, C and D class institutions below it, each with its own licence, capital requirement and permitted business.

Application of the Qualities of a Good Tax System

A good tax system must satisfy several qualities — equity, certainty, convenience, economy, elasticity, simplicity, productivity and flexibility. The application of the main qualities is explained below.

1. Equity (Ability to Pay) A tax should be levied according to the taxpayer's ability to pay. This quality is applied through progressive taxation, where the rate rises as income rises. For example, in Nepal income tax is progressive — a person earning Rs 5,00,000 pays a lower rate than one earning Rs 20,00,000. Equity is also applied through vertical equity (unequals treated unequally) and horizontal equity (equals treated equally). This reduces inequality and distributes the tax burden fairly.

2. Certainty The taxpayer should know clearly how much to pay, when to pay and how to pay. This is applied by publishing income tax rates, slabs, deadlines and penalties in the annual Finance Act. For example, the deadline for filing income tax returns in Nepal is fixed (usually Poush end for businesses), so taxpayers can plan ahead. Certainty prevents harassment by tax officials and avoids disputes.

3. Convenience Tax collection should be convenient in time, place and method. This is applied through pay-as-you-earn (PAYE) deduction of salary tax at source, collection of VAT at the point of sale, and payment through banks, mobile banking and online portals. Convenience increases voluntary compliance and reduces the cost of collection.

4. Economy The cost of collecting a tax should be small relative to its yield. This is applied by using simple administrative machinery, avoiding unnecessary tax officials and offices, and using technology such as online filing. If collection cost exceeds revenue, the tax fails this quality.

5. Elasticity and Productivity A good tax should yield more revenue when national income rises. This is applied through progressive income tax and VAT, whose revenue automatically increases with growth in income and consumption. Such taxes are productive and help the government finance rising public expenditure without raising rates.

6. Simplicity The tax law and procedure should be simple enough for an ordinary taxpayer to understand. This is applied by using clear language, fewer exemptions, simple slabs and easy forms. Simplicity reduces errors, corruption and litigation.

7. Flexibility The tax system should be adjustable to changing economic conditions. This is applied through annual budget revisions of rates and slabs, and by using built-in stabilisers such as progressive taxes that automatically dampen inflation or recession.

8. Neutrality A tax should interfere as little as possible with the taxpayer's economic decisions. This is applied by avoiding heavy taxes on essential goods and by taxing similar goods equally, so that production and consumption choices are not distorted.

Conclusion In practice, no single tax satisfies all qualities at once. A good tax system therefore applies these qualities in combination — mainly through progressive direct taxes for equity and elasticity, and broad-based indirect taxes like VAT for productivity and convenience — so that the burden is fair, collection is cheap and easy, and revenue grows with the economy.

The central bank (Nepal Rastra Bank in Nepal) is called the lender of last resort, because it is the final source of credit for commercial banks and financial institutions in times of emergency or liquidity crisis.

Money market deals in short-term funds (up to one year), while capital market deals in long-term funds (more than one year).

The classical theory of interest explains how the rate of interest is determined by the real forces of saving and investment. It is also called the real theory of interest or the loanable funds theory in its classical form, and was developed by economists like Adam Smith, Ricardo, Marshall, Pigou and Fisher. According to this theory, interest is the reward for saving and the price paid for the use of capital.

Main points of the theory:

1. Interest is a real phenomenon: The classical economists believe that the rate of interest is determined by real factors — saving and investment — and not by monetary factors. Money is only a medium of exchange and does not influence the rate of interest.

2. Supply of capital (Saving): The supply of loanable funds comes from saving. Saving depends on the rate of interest — the higher the rate of interest, the greater the saving, and vice versa. Hence the supply curve of saving slopes upward.

3. Demand for capital (Investment): The demand for loanable funds comes from investors who borrow to buy capital goods. Investment depends on the rate of interest — the lower the rate of interest, the higher the investment, and vice versa. Hence the demand curve for investment slopes downward.

4. Determination of the rate of interest: The rate of interest is determined at the point where the supply of saving equals the demand for investment. At this point, the amount saved equals the amount invested, and the corresponding rate of interest is the equilibrium rate of interest.

Diagrammatic explanation:

• The SS curve (supply of saving) slopes upward.
• The II curve (demand for investment) slopes downward.
• They intersect at point E, which gives the equilibrium rate of interest $r_e$ and equilibrium quantity of saving and investment $Q_e$.

Effects of shifts:

• If saving increases (SS shifts right), the rate of interest falls.
• If investment increases (II shifts right), the rate of interest rises.

Conclusion: In the classical theory, the rate of interest is a real variable determined solely by the forces of saving and investment. It acts as an automatic mechanism that equalises saving and investment in the economy.

A direct tax is a tax whose burden is borne by the same person on whom it is legally imposed; it cannot be shifted to another person. Income tax and property tax are examples. Its five main features are:

1. Burden cannot be shifted. The person who pays the tax to the government also bears its burden. This is the defining feature of a direct tax.

2. Progressive in nature. Rates generally rise as income or wealth rises, so the rich pay a higher rate than the poor. This promotes equity and reduces inequality of income and wealth.

3. Based on ability to pay. It is levied on income, property and wealth, which show the taxpayer's paying capacity. A person below the exemption limit pays nothing.

4. Elastic and productive source of revenue. As national income rises, collection rises automatically without changing the rate, so it is a stable source of government revenue.

5. Difficult to evade, but felt directly. Income and property are recorded in the taxpayer's name and checked through returns and audits, so evasion is comparatively hard. However, the taxpayer feels the burden directly, which may reduce the incentive to work and save.

External borrowing is the loan taken by a country or its government from foreign governments, international financial institutions (such as the World Bank or IMF), or foreign banks and private lenders to meet its financial needs.

Roles of the Banking System in Economic Development

1. Capital formation. Banks collect small, scattered savings from households and firms as deposits and channel them into productive investment as loans. By mobilising idle savings and offering interest as an incentive, banks raise the rate of capital formation, which is the base of economic growth.

2. Financing industry, trade and agriculture. Banks provide short-term, medium-term and long-term credit to industries for plant and machinery, to traders for working capital, and to farmers for seeds, fertilisers and irrigation. This ensures that no productive sector suffers for want of funds.

3. Development of infrastructure and priority sectors. Commercial banks, and in Nepal the Nepal Rastra Bank through directed lending, channel credit into roads, energy, tourism, small and cottage industries and other priority sectors. Such lending builds the infrastructure on which further production depends.

4. Promotion of trade and commerce. Through bills of exchange, letters of credit, bank guarantees, remittance services and foreign exchange facilities, banks settle domestic and international payments quickly and safely. This expands both internal and foreign trade, which in turn raises national income.

5. Support to monetary policy and price stability. The central bank uses the banking system to control credit through the bank rate, cash reserve ratio, statutory liquidity ratio and open market operations. A regulated credit supply keeps inflation under control and maintains exchange rate stability, creating a climate favourable to investment.

Besides these, banks also help in employment generation, balanced regional development, promotion of entrepreneurship and the collection of government revenue, all of which directly contribute to the economic development of the country.

Sources of Government Revenue in Nepal

Government revenue refers to the total income received by the government to meet its regular and development expenditures. In Nepal, the sources of government revenue are broadly classified into two categories: internal (domestic) sources and external (foreign) sources.

1. Internal (Domestic) Sources

a) Tax Revenue Tax is a compulsory payment made by individuals and firms to the government without any direct return. It is the largest source of government revenue in Nepal.

• Direct Taxes: These are levied on income and property of individuals and institutions. Major direct taxes in Nepal include:

  • Income tax (on individuals, firms, and companies)
  • Land revenue tax
  • House and property tax
  • Capital gains tax
  • Interest tax

• Indirect Taxes: These are levied on the production, sale, and consumption of goods and services. The burden can be shifted to consumers. Major indirect taxes in Nepal include:

  • Value Added Tax (VAT)
  • Customs duty (import and export duty)
  • Excise duty
  • Sales tax
  • Vehicle tax

b) Non-Tax Revenue This is the income earned by the government from sources other than taxes. It includes:

• Fees, fines, and penalties
• Charges for government services (passport, citizenship, registration)
• Royalties from mines and minerals
• Dividends and profits from public enterprises
• Interest earned on government loans and investments
• Rent from government land and buildings
• Sale of government property and assets

2. External (Foreign) Sources

a) Foreign Grants (Aid) Foreign grants are financial assistance received from foreign governments and international organizations without any obligation to repay. Nepal receives grants from:

• Bilateral donors (India, China, USA, UK, etc.)
• Multilateral agencies (World Bank, Asian Development Bank, UN agencies)

b) Foreign Loans These are borrowings from foreign governments and international financial institutions that must be repaid with interest. They include:

• Bilateral loans
• Multilateral loans
• Commercial loans

3. Other Sources

• Principal and interest repayment of domestic loans
• Proceeds from the sale of government bonds and treasury bills
• Miscellaneous receipts

Conclusion

In Nepal, tax revenue (especially VAT, customs duty, and income tax) forms the largest share of government revenue. However, due to a narrow tax base, low tax compliance, and a large informal economy, Nepal still depends significantly on foreign grants and loans to finance its budget deficit. Therefore, broadening the tax base and improving tax administration are essential for strengthening Nepal's fiscal position.

Commercial banks are profit-making financial institutions that accept deposits from the public and lend money to those who need it. They act as the backbone of a country's financial system. Their main functions are described below.

1. Accepting deposits The primary function of a commercial bank is to collect savings from the public in the form of deposits. It accepts three main types of deposits:

• Current account deposits: Withdrawn by cheque any number of times, no interest is paid.
• Saving account deposits: Meant for small savers, a small rate of interest is paid and there are limits on withdrawals.
• Fixed (time) account deposits: Kept for a fixed period at a higher rate of interest.

2. Advancing loans and advances Banks lend the deposits they collect to traders, industrialists and consumers and earn interest. Loans are given in the form of cash credit, overdraft, discounting of bills of exchange, and term loans. The difference between the interest paid on deposits and the interest charged on loans is the main source of bank profit.

3. Creating credit Commercial banks create credit by lending out a part of the deposits they receive. Since all depositors do not withdraw their money at the same time, banks keep only a small cash reserve and lend the rest. In this way, a small amount of initial deposit leads to a multiple expansion of credit in the economy.

4. Agency functions As an agent of its customers, a bank performs several services:

• Collects cheques, drafts and bills on behalf of customers.
• Makes payments of rent, insurance premium, loan instalments, etc.
• Purchases and sells shares and securities for customers.
• Acts as a trustee, executor and correspondent of customers.

5. General utility functions Banks also provide general services to the public, such as:

• Issuing letters of credit, bank drafts and traveller's cheques.
• Providing locker facilities for safe custody of valuables.
• Transferring money from one place to another through remittance facilities.
• Exchanging foreign currency and providing financial advice.

Conclusion Thus, commercial banks mobilise idle savings, direct them into productive investment, create credit and provide a wide range of agency and utility services. By performing these functions, they promote trade, industry and the overall economic development of the country.

Internal borrowing is the money the government raises from sources inside the country, such as treasury bills, development bonds, national savings bonds and loans from the central bank and commercial banks, to finance a budget deficit.

Government expenditure is the spending made by the government on administration, defence, development, social services and other public needs. In Nepal's budget, government expenditure is classified into three heads:

1. Recurrent (current) expenditure

Spending of a regular, routine nature that does not create physical assets. It includes salaries and allowances of civil servants, army and police, pensions, office operation costs, subsidies, social security allowances, and grants to local governments. It is the largest share of the budget.

2. Capital expenditure

Spending that creates physical assets or raises the productive capacity of the economy. It includes building roads, bridges, hydropower, airports, irrigation, schools and hospitals, and purchase of land, buildings and machinery. It is the main source of economic growth and development.

3. Financing expenditure

Spending to repay the principal of internal and external loans, and interest and other costs related to them, together with share investment. It reflects the debt-servicing burden of the government.

Other classifications used in Nepal

• By level of government: federal, provincial and local expenditure, with fiscal transfers (equalisation, conditional, special and complementary grants) to the lower levels.
• By function: general public services, defence, economic services, social services such as education and health.

Conclusion: In Nepal, recurrent expenditure is high while capital expenditure is often under-utilised, so improving capital spending and its effectiveness is important for development.

Monetary policy

Monetary policy is the policy applied by the central bank (Nepal Rastra Bank in Nepal) to control the money supply and credit in the economy through tools such as the bank rate, open market operations, cash reserve ratio and margin requirements.

Money market: the money market is the market for short-term funds, where financial instruments with a maturity of one year or less, such as treasury bills, commercial bills, call money and certificates of deposit, are bought and sold. Its main participants are the central bank, commercial banks, financial institutions and large business firms.

Four features of the money market

1. Short-term maturity: the instruments traded mature within one year, from one day (call money) to 364 days (treasury bills).
2. No fixed place: it is not a physical location. Dealings take place by telephone, internet and other communication links.
3. Wholesale market: transactions involve large amounts, so mainly big institutions such as banks, the central bank and large firms participate.
4. Highly liquid and safe: the instruments can be converted into cash quickly without much loss of value, and, being short-term and backed by the government or reputed institutions, they carry low risk.