Macroeconomics
Economics — Grade 12 | Unit 3 | NEB Nepal
Table Of Contents
Introduction
Unit 3 of NEB Grade 12 Economics covers macroeconomics at a more advanced level than Grade 11 — moving from the basic concepts of national income and money to the institutional and policy dimensions: the banking system, monetary policy, government finance (budget and taxation), and international trade. These topics are directly relevant to Nepal’s economic policy challenges — managing inflation, financing development, regulating the financial sector, and integrating into the global economy. Understanding these institutions and policies is essential for informed economic citizenship.
1. Banking System
1.1 Concept and Role of Banking
According to Walter Leaf, “A bank is an institution that takes money on deposit and lends it out at interest.” This simple definition captures the core of banking — financial intermediation between savers and borrowers.
According to R.S. Sayers, “Banks are institutions whose debts — usually referred to as bank deposits — are commonly accepted in final settlement of other people’s debts.”
According to Crowther, “A banker is a dealer in debts — his own and other people’s. He takes money on deposit from the public and lends that money out to borrowers, making a profit on the difference between borrowing and lending rates.”
The role of the banking system in economic development includes:
i. Financial intermediation: Banks channel savings from households to productive investment by firms — converting idle savings into working capital and investment funds.
ii. Credit creation: Commercial banks multiply the money supply through the credit creation process — receiving deposits, keeping a fraction as reserves, and lending the rest, which becomes deposits in other banks and is re-lent, creating a multiple expansion of credit.
iii. Payment services: Banks provide payment mechanisms — cheques, electronic transfers, debit cards, mobile banking — that facilitate trade and economic activity.
iv. Risk diversification: By pooling funds from many depositors and lending to many borrowers, banks diversify risk that individual savers cannot.
v. Economic development: Banks provide credit for agricultural investment, small business development, and industrial expansion — directly supporting Nepal’s economic growth.
1.2 Classification of Banks in Nepal
Nepal’s banking sector is regulated by the Nepal Rastra Bank (NRB) under the Nepal Rastra Bank Act, 2058 BS and the Banks and Financial Institutions Act (BAFIA), 2073 BS.
Class A — Commercial Banks (Banks):
- Largest and most comprehensive banking institutions
- Provide full range of banking services: deposits, loans, trade finance, foreign exchange, investment banking
- Examples: Nepal Rastra Bank, Nabil Bank, Everest Bank, NIC Asia Bank, Standard Chartered Bank Nepal
- Minimum paid-up capital: Rs. 8 billion (currently)
Class B — Development Banks:
- Serve specific sectors or regions — agriculture, industry, housing, infrastructure
- Provide medium and long-term credit for development activities
- Examples: Nepal Development Bank, Excel Development Bank
Class C — Finance Companies:
- Provide hire purchase, leasing, and instalment credit
- Smaller in scale than development banks
Class D — Microfinance Financial Institutions (MFIs):
- Provide small-scale financial services to low-income households and micro-enterprises
- Critical for financial inclusion in rural Nepal
- Examples: Nirdhan Utthan Bank, DEPROSC Development Bank, thousands of savings and credit cooperatives
1.3 Central Bank (Nepal Rastra Bank)
According to M.H. De Kock, “A central bank may be defined as a bank which constitutes the apex of the monetary and banking structure of the country and which performs as best it can in the national economic interest.”
According to W.A. Shaw, “The central bank is a bank that controls credit in the country and acts as a lender of last resort to the banking system.”
Nepal Rastra Bank (NRB) was established in 2013 BS (1956 AD) under the Nepal Rastra Bank Act. It is Nepal’s central bank and the apex monetary authority.
Functions of Nepal Rastra Bank (Central Bank):
i. Issue of Currency: NRB has the exclusive right to issue legal tender currency in Nepal. Monopoly of note issue ensures standardization and public confidence.
ii. Banker to the Government: NRB acts as the government’s banker — maintaining government accounts, managing public debt, advising on fiscal policy, and providing short-term loans to the government.
iii. Banker’s Bank and Lender of Last Resort: NRB holds the reserves of commercial banks, provides emergency liquidity to banks facing temporary shortfalls, and oversees the clearing and settlement of interbank transactions. As lender of last resort, NRB prevents bank runs from becoming systemic crises.
iv. Custodian of Foreign Exchange Reserves: NRB manages Nepal’s foreign exchange reserves — approximately USD 11–12 billion — invested in safe international assets to cover import needs and maintain exchange rate stability.
v. Controller of Credit (Monetary Policy): NRB uses monetary policy tools to regulate money supply and credit, targeting inflation and economic stability.
vi. Regulation and Supervision of Banks: NRB licenses, regulates, and supervises all banks and financial institutions — setting capital adequacy requirements, conducting on-site inspections, and enforcing prudential standards.
vii. Maintenance of Exchange Rate: NRB manages Nepal’s exchange rate — currently a fixed peg to the Indian Rupee at NPR/INR 1.6 — through intervention in the foreign exchange market.
viii. Development of Financial System: NRB promotes the development of Nepal’s financial sector — expanding access to banking services, developing capital markets, and modernizing payment systems.
1.4 Functions of Commercial Banks
According to R.S. Sayers, “The essential functions of a commercial bank are: to collect deposits and to make loans and advances.”
Primary functions:
i. Accepting deposits: Commercial banks accept deposits from the public in various forms:
- Current (Demand) deposits: Withdrawable on demand; no interest; used for transactions
- Savings deposits: Earn interest; withdrawal restrictions; encourage saving habits
- Fixed (Time) deposits: Deposited for a fixed period; higher interest; cannot be withdrawn before maturity
ii. Advancing loans and credit:
- Cash credit: Credit against collateral security — borrower withdraws up to a sanctioned limit
- Overdraft: Facility to withdraw more than the current account balance — up to an agreed limit
- Discounting bills: Bank buys bills of exchange at a discount — providing immediate liquidity to businesses
- Term loans: Fixed amount lent for a specific period — for business investment, housing, vehicle purchase
Secondary functions:
iii. Agency services: Banks act as agents for customers — paying utility bills, collecting cheques, executing stock market transactions, remitting funds.
iv. Safe custody: Providing safe deposit vaults for valuables, documents, and securities.
v. Foreign exchange: Buying and selling foreign currencies; facilitating international trade payments; issuing letters of credit.
vi. Credit cards, debit cards, and digital banking: Providing payment instruments and digital banking platforms that enable electronic commerce.
1.5 Credit Creation by Commercial Banks
Credit creation (also called money creation or deposit multiplication) is the process through which commercial banks expand the money supply by lending multiples of their initial deposits.
The mechanism:
- A depositor places Rs. 10,000 in Bank A
- Bank A keeps 10% (Rs. 1,000) as required reserve and lends Rs. 9,000
- The Rs. 9,000 loan is deposited in Bank B
- Bank B keeps 10% (Rs. 900) and lends Rs. 8,100
- This process continues — each lending creates a new deposit
Credit Multiplier (Money Multiplier):
$\text{Credit Multiplier} = \frac{1}{\text{Required Reserve Ratio}} = \frac{1}{r}$
Total credit created = Initial deposit × Credit multiplier = D × (1/r)
Example: If initial deposit = Rs. 10,000 and reserve ratio = 10% (0.10): Credit multiplier = 1/0.10 = 10 Total credit created = Rs. 10,000 × 10 = Rs. 1,00,000
According to John Maynard Keynes, “Banks do not merely lend money — they create it. The process of credit creation by the banking system is one of the primary mechanisms through which the money supply expands.”
Limitations of credit creation:
- The reserve ratio (set by NRB) limits the multiplier
- Public’s preference for holding cash rather than deposits reduces the deposit base
- Availability of creditworthy borrowers — if demand for loans is low, banks cannot force credit expansion
- NRB’s monetary policy tools can restrict or expand credit creation
1.6 Capital Market and Money Market
Money Market: The market for short-term funds (maturity up to one year) — Treasury Bills, interbank loans, commercial paper, certificates of deposit. Instruments are highly liquid and low-risk.
Capital Market: The market for long-term funds (maturity over one year) — shares (equity), bonds (debentures), and long-term bank loans. Instruments finance long-term investment.
Nepal’s Capital Market: The Nepal Stock Exchange (NEPSE) is Nepal’s primary securities exchange — listing shares of banks, insurance companies, hydropower companies, and other listed firms. SEBON (Securities Board of Nepal) regulates the capital market.
2. Monetary Policy
2.1 Meaning and Objectives
According to Paul A. Samuelson and William D. Nordhaus, “Monetary policy refers to the measures undertaken by the central bank to regulate the money supply, credit conditions, and interest rates in order to achieve macroeconomic objectives.”
According to M.H. De Kock, “Monetary policy is a policy which employs the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.”
According to John Maynard Keynes, “The state of the art of monetary policy lies in the manipulation of interest rates and credit conditions to influence investment, employment, and the price level.”
Primary objectives of monetary policy:
- Price stability: Maintaining low and stable inflation — Nepal Rastra Bank targets inflation in the 5–7% range
- Full employment: Supporting conditions for maximum productive employment
- Economic growth: Providing adequate credit for productive investment
- Exchange rate stability: Maintaining the NPR/INR peg and adequate foreign exchange reserves
- Financial system stability: Preventing banking crises and maintaining public confidence in the financial system
2.2 Types of Monetary Policy
Expansionary (Easy/Loose) Monetary Policy: Increases money supply and reduces interest rates — stimulating borrowing, investment, and aggregate demand. Used during recessions and periods of high unemployment.
Contractionary (Tight) Monetary Policy: Reduces money supply and raises interest rates — reducing borrowing and spending to combat inflation. Used when inflation is rising above target.
2.3 Instruments of Monetary Policy
Quantitative (General) Instruments — affect the overall volume of credit:
i. Bank Rate (Discount Rate): The interest rate at which NRB lends to commercial banks. Raising the bank rate increases the cost of borrowing from NRB → commercial banks raise their own lending rates → credit becomes more expensive → investment and spending fall → inflation is reduced.
ii. Open Market Operations (OMO): NRB buys or sells government securities (Treasury Bills, government bonds) in the open market.
- Selling securities: Reduces commercial bank reserves → banks have less to lend → money supply falls (contractionary)
- Buying securities: Increases commercial bank reserves → banks can lend more → money supply rises (expansionary)
iii. Cash Reserve Ratio (CRR): The minimum percentage of deposits that commercial banks must hold as cash reserves with NRB (not available for lending).
- Raising CRR: Banks hold more reserves → less available to lend → money supply falls
- Lowering CRR: Banks hold fewer reserves → more available to lend → money supply rises
iv. Statutory Liquidity Ratio (SLR): The minimum percentage of deposits that banks must maintain in liquid assets (cash, gold, government securities).
Qualitative (Selective) Instruments — direct credit to specific sectors or users:
v. Selective Credit Controls: NRB directs banks to lend (or not lend) to specific sectors — requiring minimum lending to agriculture, microfinance, or priority sectors; restricting lending to overheating sectors (real estate, stock market margin lending).
vi. Moral Suasion: NRB uses informal persuasion — meetings, guidelines, public statements — to influence bank behaviour without formal regulation.
vii. Credit Rationing: Setting limits on total credit or on credit to specific sectors.
3. Government Finance
3.1 Government Budget
According to Paul A. Samuelson, “The government budget is the most important fiscal document — it sets out the government’s plans for revenue and expenditure and defines its fiscal stance for the coming year.”
Nepal’s government presents its annual budget on 1 Ashadh (approximately mid-June) — a major economic event determining public investment priorities, tax rates, and social expenditure for the coming fiscal year.
Components of Government Revenue:
i. Tax Revenue:
- Direct taxes: Income tax, corporate tax, capital gains tax — levied on income and wealth directly
- Indirect taxes: Value Added Tax (VAT at 13%), customs duties, excise duties — levied on transactions
ii. Non-Tax Revenue: Dividends from public enterprises, fees and charges, foreign grants
Composition of Government Expenditure:
i. Recurrent (Current) Expenditure: Civil servant salaries, operation of government services, interest payments on debt, grants to provinces and local governments
ii. Capital (Development) Expenditure: Investment in roads, hydropower, irrigation, schools, hospitals — the most growth-impactful component
iii. Financing Expenditure: Loan repayments, financial investments in public enterprises
3.2 Taxation
According to Philip E. Taylor, “Taxes are compulsory payments to the government without expectation of direct benefit to the taxpayer.”
According to Adam Smith, a good tax system should satisfy four canons: Equity (taxes proportional to ability to pay), Certainty (clear and known to taxpayers), Convenience (easy to pay), and Economy (low collection costs relative to revenue).
Direct Taxes in Nepal (Income Tax Act, 2058 BS):
- Personal income tax (progressive rates: 1% to 36%)
- Corporate tax (25% standard rate; 20% for manufacturing; 30% for banks/insurance)
- Capital gains tax on sale of shares and property
Indirect Taxes in Nepal:
- VAT (13%): Major revenue source — collected monthly by VAT-registered businesses
- Customs duties: On imports through Nepal’s border customs points
- Excise duties: On domestic production of alcohol, tobacco, petroleum, vehicles
Tax-to-GDP ratio: Nepal’s tax revenue as a percentage of GDP is approximately 22–24% — relatively high for a low-income country but insufficient to fully finance development needs without foreign aid and borrowing.
3.3 Budget Deficit and Public Debt
Nepal consistently runs a budget deficit — expenditure exceeds domestic revenue:
Budget Deficit = Government Expenditure − Government Revenue
Financing of Nepal’s budget deficit:
- Foreign aid and grants: Substantial contributions from development partners (India, China, US, UK, EU, World Bank, ADB)
- Foreign loans: Concessional loans from multilateral institutions (World Bank IDA, ADB, IMF) and bilateral donors
- Domestic borrowing: Treasury bills and government bonds sold to banks and the public
- Central bank financing: NRB provides temporary advances to the government (limited under the NRB Act)
Public debt sustainability: Nepal’s external debt is approximately 25–30% of GDP — moderate by international standards but growing. Debt service (repayment of principal and interest) consumes an increasing share of the budget.
4. International Trade
4.1 Concept and Basis of International Trade
According to Bertil Ohlin, “International trade arises because different countries are endowed with different factors of production — countries export goods that use their abundant factors intensively and import goods that use their scarce factors intensively.”
According to David Ricardo’s principle of comparative advantage, “Even if one country is absolutely more efficient in producing all goods, both countries gain from specializing in and trading the goods at which each has a comparative (relative) advantage — the good at which its opportunity cost is lower.”
According to Paul Samuelson, “The gains from trade arise from specialization — by concentrating on activities for which they are relatively best suited, countries can collectively produce more than if each tried to be self-sufficient.”
Basis of international trade:
- Differences in factor endowments (Heckscher-Ohlin theory): Countries export goods produced with their abundant factors
- Comparative advantage (Ricardo): Differences in relative productivity justify specialization and trade
- Economies of scale: Large-scale production made possible by access to larger markets
- Product differentiation: Trade in varieties of similar products (intra-industry trade)
4.2 Benefits of International Trade
i. Access to goods not available domestically: Nepal imports petroleum (entirely), machinery, chemicals, and many consumer goods that cannot be produced domestically.
ii. Lower prices through competition: Import competition disciplines domestic producers to improve efficiency and keep prices competitive.
iii. Access to larger markets: Nepal’s carpet, pashmina, and tea producers can sell to global markets far larger than Nepal’s 30 million domestic consumers.
iv. Technology and knowledge transfer: Importing capital goods and foreign direct investment brings new technology and management practices.
v. Economic growth: Trade enables specialization and scale economies that raise productivity and income.
vi. Foreign exchange earnings: Exports generate the foreign exchange needed to pay for imports — critical for a trade-deficit country like Nepal.
4.3 Balance of Trade and Balance of Payments
Balance of Trade (BOT): The difference between a country’s merchandise exports and merchandise imports.
BOT = Value of Merchandise Exports − Value of Merchandise Imports
- Trade surplus: Exports > Imports (BOT positive)
- Trade deficit: Imports > Exports (BOT negative)
Nepal has a persistent and large trade deficit — imports of approximately USD 14–15 billion significantly exceed merchandise exports of approximately USD 1.5 billion. Nepal’s trade deficit is financed primarily by remittances.
Balance of Payments (BOP): A comprehensive record of all economic transactions between a country and the rest of the world over a given period.
According to Kindleberger, “The balance of payments is a systematic record of all economic transactions between residents of the reporting country and residents of all other countries.”
Components of BOP:
i. Current Account:
- Trade in goods (merchandise): Exports minus imports
- Trade in services: Tourism receipts, transport, financial services
- Primary income: Worker remittances, investment income
- Secondary income: Transfers, foreign aid
ii. Capital Account: Transfers of capital — debt forgiveness, grants for capital projects
iii. Financial Account: Foreign direct investment (FDI), portfolio investment, other financial flows, change in foreign exchange reserves
Nepal’s BOP: Nepal’s current account was historically in surplus (despite the large trade deficit) because remittances more than compensated for the trade deficit. However, when imports surged after COVID-19, Nepal’s current account turned negative in 2022–23, causing a foreign exchange reserve crisis that required emergency monetary policy tightening.
4.4 Free Trade and Protectionism
Free Trade: A trade policy that allows goods and services to be traded across borders without government-imposed restrictions (tariffs, quotas, subsidies).
According to Adam Smith, “It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. What is prudent in the conduct of every private family can scarce be folly in that of a great kingdom.” The case for free trade rests on comparative advantage and the gains from specialization.
Protectionism: Government policies that restrict imports and/or promote exports to protect domestic industries.
Instruments of protection:
- Tariffs (customs duties): Taxes on imports — raising the price of imported goods to protect domestic producers
- Import quotas: Physical limits on the quantity of specific imports
- Subsidies to domestic producers: Reducing costs of domestic production to compete with cheaper imports
- Non-tariff barriers: Technical standards, safety regulations, administrative delays that discourage imports
Arguments for protectionism:
i. Infant industry argument: According to John Stuart Mill, new domestic industries may need temporary protection while they develop scale, skills, and technology to compete with established foreign firms. Once competitive, protection should be withdrawn.
ii. Employment protection: Import competition may cause unemployment in industries that cannot compete — temporary protection gives workers time to retrain and industries to adjust.
iii. National security: Some industries (defence, food, energy) must be maintained domestically regardless of comparative advantage — for strategic security reasons.
iv. Terms of trade improvement: A large country may use tariffs to improve its terms of trade — forcing foreign exporters to lower prices.
v. Balance of payments: Import restrictions reduce the trade deficit.
Arguments against protectionism:
- Raises prices for domestic consumers
- Reduces efficiency by protecting inefficient domestic producers
- Invites retaliation by trading partners
- Deadweight welfare losses similar to monopoly
4.5 International Trade Organizations
i. World Trade Organization (WTO):
According to the WTO, “The World Trade Organization is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations.”
Nepal became a WTO member in 2004 — the first Least Developed Country to accede through full working party negotiations. WTO membership gives Nepal access to most-favoured-nation (MFN) treatment from all WTO members and preferential access through the LDC waiver.
Key WTO principles:
- Most Favoured Nation (MFN): Trade concessions given to any WTO member must be given to all
- National Treatment: Imported goods must be treated no less favourably than domestically produced goods
- Transparency: Trade laws and regulations must be published and notified
ii. SAFTA (South Asian Free Trade Area):
SAFTA is a free trade agreement among SAARC members — Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri Lanka, and Afghanistan. It aims to progressively reduce tariffs on intra-SAARC trade toward zero.
Nepal’s trade is dominated by India — approximately 60–65% of both imports and exports flow through the India-Nepal trade corridor. The India-Nepal Trade Treaty provides for preferential access of Nepali goods to the Indian market and forms the bedrock of Nepal’s trade policy.
5. Macroeconomics in Nepal’s Context
i. NRB’s monetary challenges: Nepal faces the classic challenge of a small open economy with a fixed exchange rate — monetary policy is significantly constrained by the NPR/INR peg. To maintain the peg, NRB must maintain interest rate parity with India, limiting independent monetary policy.
ii. The 2022–23 foreign exchange crisis: A surge in imports after COVID-19 depleted Nepal’s foreign exchange reserves to critically low levels in 2022. NRB responded with aggressive contractionary monetary policy — raising interest rates and restricting imports of luxury goods — demonstrating the real-world application of monetary policy tools.
iii. Budget execution challenge: Nepal consistently underutilizes its capital budget — spending less than 70% of allocated development funds in many years due to procurement delays, political instability, and implementation capacity gaps. This limits the effectiveness of fiscal policy as a development tool.
iv. Trade deficit and remittance dependence: Nepal’s enormous trade deficit (imports approximately 10× exports by value) is structurally unsustainable without the remittance inflows that currently finance it. Diversifying exports — through hydropower export, tourism recovery, and industrial development — is a strategic imperative.
v. WTO and SAFTA implications: Nepal’s WTO membership requires maintaining open trade policies — limiting the use of protectionist measures. At the same time, Nepal’s LDC status provides transitional flexibilities and preferential market access. Navigating this balance — protecting developing industries while meeting WTO commitments — is a key trade policy challenge.
Conclusion
Macroeconomics at the Grade 12 level connects the theoretical foundations of national income and money (Grade 11) to the institutional realities of the banking system, central bank operations, government finance, and international trade. These institutions — Nepal Rastra Bank, the commercial banking system, the annual budget, and Nepal’s trade relationships — are not abstract entities but the concrete mechanisms through which Nepal’s economic policy is designed and implemented.
As John Maynard Keynes observed, “The difficulty lies not so much in developing new ideas as in escaping from old ones.” For Nepal’s economic policymakers — and for the students who will become tomorrow’s policymakers — the macroeconomic frameworks in this unit provide the conceptual tools needed to think clearly about Nepal’s most pressing economic challenges: inflation management, financial sector development, fiscal sustainability, and integration into the global economy.
Prepared for NEB Grade 12 Economics — Unit 3: Macroeconomics Aligned with the National Curriculum Framework 2076, Curriculum Development Centre, Sanothimi, Bhaktapur
