Banking System and Monetary Policy | NEB Class 12 Economics

Banking System & Monetary Institutions

Bank is a financial institution which deals with money & credits. It accepts deposits of money from public in different accounts & provides loans to the needy person.

1. Role of Banking System (VIVID)

• a) Mobilization of savings: Commercial bank from different accounts. Such collected money is lent to productive sector.
• b) Monetization of Economy: To accelerate trade & commerce monetization of economy is necessary. Bank & financial institution provides services & because of this people become habitual with banks. People maintain saving, withdraw their saving & further bank provides opportunities & flow of money.
• c) Capital formation: Banks collects saving & mobilize in productive sector. Business institution uses their funds to purchase capital good to produce goods & service. So without banking system capital formation becomes extremely difficult.
• d) Remittance of money.
• e) Manage foreign trade & payment.
• f) Creation of employment opportunities.
• g) To meet development expenditure of the government.

Central Bank

Central Bank is the supreme bank of the country. It is the apex of monetary banking structure of a country. It regulates, guides & develops banking structure of a country. Nepal Rastra Bank is the central Bank of Nepal established on 14 Baishakh 2013 B.S.

Functions

1. Monopoly of note issue
2. Control of credit
3. Custodian of the foreign currency / for metals
4. Provides clearing house facilities
5. Lender of last resort

Commercial Bank (VVIP)

Commercial bank is financial institution established in order to earn profit during its banking business. It accepts deposits of money from general public & advances loan for commercial purposes to businessman, trades, individuals etc. Fills the gap between savers & investors. Until the end of 2023, there are total of 20 commercial banks in Nepal.

Functions

A) Primary functions

1) Accepting deposit: These banks accept deposits from general public. A commercial bank accepts deposits into three different accounts.

• a) Current Account: It is the account the bank does not pay any interest to deposits. Generally business entity that has made payment everyday, deposit on their account. Deposits are made for security sake rather than to earn interest.
• b) Saving Account: Small savers deposit this saving in this account. Depositor earn interest; when they are in need they can withdraw their deposits. Bank pay some interest to this account.
• c) Fixed Accounts: Depositor deposit their money for fixed period of time. Banks pay relatively higher rate of interest than saving accounts. If depositor withdraw before the maturity, the bank levies some charges.

B) Provides loan: Commercial bank advances loan for commercial purpose to businessman, trades, producers etc. Bank offers short term, mid-term, long-term loans.

• a) Cash credit: Is provided by keeping collateral or security deposit in bank. Bank issues loan in the form of cash.
• b) Overdraft: Is facility of withdrawing excess money which is more than deposited amount in one's account. Such facility is provided for selected customers by charging certain rate of interest on amount.
• (2) Discounting bills of exchange: Bill holder may get loan as using bills as collateral. Bills of exchange, promissory notes etc. are discounted & needy get the percentage value of the bill as loan.

2. Secondary function

• A) Remittance of money
• B) Purchase or sale of securities
• C) Income receiving & payment

3. Contingent functions

• a) Safety of valuable goods
• b) Issue of credit instrument
• c) Foreign exchange operation

Financial Market

Are those markets where firms & government sell financial assets to raise funds for investors buy financial assets to invest their money. Bonds, shares, debentures, treasury bill etc. are example of financial assets. Financial market is divided into two categories.

Money market

It is the mechanism through which short term funds are raised / provided in trade, commerce & industry sector.

Capital Market

It is a mechanism through which long-term funds are raised / provided in trade, commerce & industry sector.

Monetary Policy

Monetary Policy is one of the macroeconomic policies of the government where central bank manages & control the money supply & interest rate to influence the economic activity. It is a policy affecting the quantity of money which determines the cost & availability of credit.

Types of Monetary Policy

1. Expansionary Monetary Policy

Also known as the loose monetary policy. It is used by central bank to stimulate economic activities. Such policy increases money supply, reduces the rate of interest which helps to increase aggregate demand; further government which helps to increase government expenditure & reduce rate of tax. It helps to increase consumption & investment activities.

2. Contractionary Monetary Policy

Also known as tight monetary policy. Here central bank reduces quantity of money supply in the economy, increases rate of interest thus decreasing aggregate demand. Also government reduces its spending, increases taxes. It aims to reduce / control inflation by reducing demand for money for consumption & investment purpose.

Human Development Index (HDI)

HDI is a composite index or statistical tool used to measure country's overall achievement in the economic & social dimensions. HDI was developed by Mahbub ul Haq published by United Nations Development Programme (UNDP) in 1990. The HDI is an index that measures the key dimension of education and a decent standard of living. These dimensions are examined to create overall score between 0–1. Here 1 indicates a high level of economic development & 0 a very low level. It provides a broader measure of well-being & is used to rank countries based on their level of human development.

Three aspects

• Long & healthy life: Is measured by life expectancy at birth. A higher life expectancy indicates better health care, nutrition & overall well-being in a country.
• Knowledge (Education): It is measured by two indicators.
  • Mean years of schooling: The average number of years of education received by adults aged 25 & older.
  • Expected years of schooling: The number of years a child is expected to spend in school based on current enrollment rates. $$^{1/3}$$ weight is given to mean year of schooling, $$^{2/3}$$ weight to expected years of schooling.
• Standard of living: Is measured by the Gross National Income (GNI) per capita. GNI per capita reflects a country's economic output per person. A higher GNI per capita indicates better economic prosperity & access to goods & services.

To calculate HDI each dimension is normalized & is scaled to value between 0 and 1.

$$\text{Dimension Index} = \frac{\text{Actual Value} - \text{Minimum Value}}{\text{Maximum Value} - \text{Minimum Value}}$$

HDI is geometric mean of the three dimensional indices.

$$HDI = (\text{Health Index} \times \text{Education Index} \times \text{Income Index})^{1/3}$$

All countries are ranked into four development groups on the basis of their HDI:

Minimum & maximum values (goal posts) are set in order to transform the indicators expressed in different units into indices between 0 and 1.

HDI highlight disparities in health, education & income across countries. It encourages policy to focus on improving human well-being rather than just economic growth.

Limitations

1. Ignores important factor like sustainability, gender equality & political freedom.
2. Does not account for disparities within a country.
3. It does not fully capture wealth distribution or informal economic activities.