Monetary Policy Transmission : Context Nepal

Monetary transmission refers to the process by which the impact of the monetary policy actions passes on to its ultimate goal or the real sector of the economy. Changes made in money supply and policy rates will bring change in aggregate demand such that improvements would be brought in monetary policy objectives such as employment, price and output as desired. That is why monetary policy is also called demand management policy.

Main Transmission Channels 

1    1. Interest Rate Channel:

Interest rate channel is the traditional and most widely used channel in monetary transmission mechanism. According to this channel, when the monetary policy rates are changed, it causes changes in the short term interest rates which will ultimately bring changes in long term interest rates. Such changes affect the demand for credit and the aggregate demand of the economy. Change in aggregate demand, in turn, will influence real sectors such as employment, output and price level. The working mechanism of this channel can be shown in the chart below: 

The effectiveness of this channel depends on the structure of the economy and the level of the development of the financial markets. If the relationship between interest rate and the demand for credit is weak, this channel is not effective. In such a case if the central bank reduces interest rate by adopting expansionary monetary policy, the demand for credit does not rise as expected as such the impact on aggregate demand is minimum. Alternative transmission channel should be used in such a case.

      2.     Asset Price Channel:

In this channel, the policy actions of the monetary authority brings changes in value of assets (real estate, security) of households and business firms which in turn change the aggregate demand of the economy. For instance if expansionary monetary policy is used resulting in an increase in the prices of equity and real estate, it will raise the consumption demand of the households and investment demand of the firms. An increase in aggregate demand will in turn results in an increase in output, price and employment.

According to this channel, the impact of monetary policy actions is transmitted through two mediums:

A. Tobin's q :

Tobin's q ratio shows the relationship between the market value of the company and its book value. A q-ratio greater than one is indicative of higher market value which gives incentive to investment. If expansionary monetary policy raises the market value of the company by reducing interest rate, the investment demand of the economy will increase thereby pushing the aggregate demand upwards. 
B. Wealth Effect

Wealth effect works through the changes in the financial and physical assets of the households due to monetary policy actions. Such changes affect the consumption and investment behaviors of the households thereby affecting the aggregate demand of the economy. For instance, if expansionary monetary policy leads to an increase in equity and real estate prices, it will increase the consumption and investment demand of the households and raises output, employment and price level by raising the aggregate demand.

The working mechanism of this channel can be shown in the chart below: 

This channel will be effective when there is a clear and strong relationship between interest rate and asset prices.

 3.     Credit Channel

Credit channel is the direct transmission channel of monetary policy. Under this channel, changes in monetary policy actions change the credit availability which brings changes in consumption and investment demand. This channel can be effective in credit deficient economy where availability of credit is more important rather than the cost of credit. Such a situation exists in underdeveloped countries where the allocation of financial resources is generally sub-optimal.

The working mechanism of this channel can be shown in the chart below:

 4.     Exchange Rate Channel

Under this channel, change in monetary policy actions influences the exchange rate of the economy which in turn influences the export and import demand. For instance, if the central bank adopts expansionary policy, interest rate decreases which reduces the capital inflow resulting into a fall in the supply of foreign exchange. Reduction in foreign exchange creates pressure in BOP as such the domestic currency depreciates. It encourages export and discourages imports. As a consequent of this, the aggregate demand of the economy rises.

The working mechanism of this channel can be shown in the chart below: 

For this channel to be effective:

• The country should have adopted the flexible exchange rate regime.
• Capital account must be convertible.
• Exports should be sensitive to devaluation i.e. price elasticity of exports should be high.  

       5.     Expectation Channel

The expectations made by economic agents about economy also influence transmission of monetary policy. Such expectations will affect consumption and investment decision of the agents and thus affect aggregate demand.  This channel can be effective only if the financial and economic sectors are well developed.

The working mechanism of this channel can be shown in the chart below:

 Effectiveness of Monetary Policy Transmission Channels

• The effectiveness of monetary policy transmission mechanism depends on the economic and financial sector development, institutional and policy framework and monetary policy framework, among others.

• The price based transmission mechanisms are less useful in underdeveloped economies due to the weak relationship between interest rate, exchange rate and investment. 

•  According to an IMF study, the credit channel of the monetary policy is more effective in UDCs.

• In Nepal the impact of changes in policy rate on interest rate is not much strong and the impact of changes in interest rate on consumption, investment, output and employment is minimal. Investment decision is rather affected by policy regime, internal rate of return, political stability, labor relation and others.

• Since Nepal has adopted pegged exchange rate regime and capital account is only partially convertible, the exchange rate mechanism has limited role to play.

• The asset price channel seems to work to some extent as the monetary policy actions often brings changes in the real estate prices and share prices. However, such increase has meager effect on the real sector of the economy including output and employment. This is due to the underdeveloped capital and real estate sector.

• In Nepal, different empirical studies have emphasized the use of credit channel as an effective channel. They include Khatiwada (2005), Kharel (2012), Budha (2013). This channel works well when access to financial services is low, the market is less competitive, there is lack of capital and the environment is not much supportive for large scale investment.

• For transmission mechanism to effectively operate, independence of monetary policy is must.  The situation of pegged exchange rate system with India, convergence of Nepal’s inflation to the Indian inflation, the labor mobility and the long-open border with India raise question on independence of Nepalese monetary policy.

           The monetary transmission channels are not substitutes of each other. Rather they may complement each other while working to attain the final target of the policy.  In Nepalese context, among different channels of monetary policy transmission, bank lending channel is more effective. Other channels at the same time complement it to attain the desired targets of the policy.

Financial Literacy around the World

Financial Literacy
Financial literacy refers to the knowledge about the financial aspects of one life. It is not limited to the awareness of banking services available in your area. Rather it covers the way you make your budget, are you aware of the advantages of saving or not, where to save and why?, from where to take loan?, What financial institutions and products are available in your area, etc. Thus, financial literacy is about having skills and knowledge that help to make informed and effective financial decisions.

According to OECD, "Financial literacy is a combination of awareness, knowledge, skills, behavior and attitude necessary to make sound financial decisions."

Components of Financial Literacy 

1. Budget : 

It refers to the skills for prioritization of necessities and economic allocation of resources.

2. Savings : 

It refers to the knowledge about the benefits of savings, where and how to save safely and profitably.

3. Loan Management :

 It refers to the knowledge about the advantages and disadvantages of taking loans, proper utilization of loans.  It requires a knowledge about where to take loan from and how to take.
 4.  Investment :

 It refers to the knowledge of analyzing the profitable sources of investment and investing in the best ones.

5. Risk Management : 

It requires the knowledge of minimizing the risk through insurance and other measures.

6. Types of Financial Institutions, Services Provided by Them and Use of Technology : 

This is  perhaps the most important component of financial literacy. It demand knowledge about the financial institutions available and the services provided by them and the use of technology in handling the financial transactions .

Financial Literacy in the World 

-Only 33 percent adults are financially literate.

-35 percent of men and 30 percent of women are financially literate. 

-Most of the financially illiterate adults live in developing and underdeveloped countries.

-In the chart below, the darker regions imply more percentage of financially literate adults.

Source : http://gflec.org/initiatives/sp-global-finlit-survey/

-Country wise, financial literacy ranges from 13 percent to 71 percent.
-In Nepal, 18 percent of the adults are financially literate. 

Source : http://gflec.org/initiatives/sp-global-finlit-survey/

 Read the full report here

Limitations of Nepalese Monetary Policy

The Central Bank of Nepal is implementing monetary policy since 2002/03 with the objective of maintaining price and external sector stability, increasing financial access and maintaining financial sector stability. The policy has been largely successful in its objectives though there are constraints from supply side and external sector. Due to its fixed exchange rate regime with India, underdevelopment of  financial market, the large size of informal economy and structural constraints, the effectiveness of the policy has somewhat challenged. Such constraints include:

1. Pegged Exchange Rate with India:

In a pegged exchange rate economy, the Central Bank must buy and sell foreign currency in foreign exchange market so as to maintain the pegged rate. In such intervention, if, for example, there is an excess supply of Indian currency in the market, the Central Bank must purchase it so as to prevent an appreciation of Nepalese currency thereby increasing the supply of Nepalese currency in the market. On the other hand, if there is excess demand for Indian currency in the market, the Central Bank must either increase the supply of Indian currency if it is possible or reduce the supply of domestic currency so that people's demand for Indian goods and services falls with a reduction in demand for IC. Whatever the Central Bank does, it's objective is to maintain the peg and the primary objective of price stability may be sacrificed. 

2. Large Informal Sector :

Many studies carried out so far has shown that  40 to 50 percent of the economic activities in the economy are done in an informal way that are out of notice of the government. The informal trade with India is a very good example. In such a market, the demand for and supply of money is hard to be predicted. And it becomes difficult to carry out monetary management in an effective way. 

3. Shadow Banking

In Nepal, besides the banks and financial sector, there are a bunch of other formal and informal institutions that carry our the functions similar to the banks. Some formal institutions include:Employee Provident Fund, Citizenship Investment Trust, Insurance Companies, Cooperatives, etc. The informal ones includes saving groups, dhukuti system, village money lenders, friends and relatives. The financial access survey carried out by UNCDF shows that only 40 percent of Nepalese adults have access to banks and financial institutions, the other 20 percent have access to other formal institutions and the rest are either served by the informal sector or completely out of financial access. This makes both the functions of monetary management and expansion of financial access challenging.

4. Under development of Financial Market

Due to the underdevelopment of money and capital markets, several challenges have been created:

a. There are not enough instruments available in the money market so that the Central Bank  can effectively manage short term liquidity. 

b. The imperfections in the market do not let the interest rate to be settled in realistic range. 

c. Due to underdeveloped capital market, the banking system has to finance the long term capital requirements including hydro-power and other infrastructures. But it's resources are mostly short and medium term, collected through saving and fixed deposit accounts. Such tendency has often created a problem of maturity mismatch in the banking sector. 

5. External Shocks:

Due to the fixed exchange rate regime, there is no mechanism to absorb the shocks that originate in the world market. Thus, the sharp changes in the petroleum prices, shocks in international exchange rates etc are directly transmitted to Nepal. 

6.Supply Side and Structural Constraints:

The supply side constraints like cartelling practices, artificial shortages, lack of information, lack of transport infrastructure, low skilled labor force, lack of agricultural infrastructures have created a challenge to control the inflationary pressures originating from the supply side. In such a case, the demand management policies from the monetary authority have lost their strength in many cases. 

7.Policy Lags 

There are many policy lags in all macroeconomic policies in general including :

a. Recognition Lag : It takes time to recognize the problem. 

b. Decision Lag: It takes time to take a policy decision. 

c.Implementation Lag:  It takes time to implement the policy decision. 

d. Impact lag : It takes some time for the policy decision to show its impact. 

These lags makes it challenging to solve the policy problem immediately. 

Monetary policy is a demand management policy that tries to maintain price and external sector stability in the economy. However, for doing so, it must have sufficient instruments and proper market infrastructures. In Nepal, the pegged exchange rate regime with Indian Currency as well as the structural and supply side constraints have posed some challenges to the effective implementation of monetary policy. Even then, it has been largely successful in achieving its objectives so far.