Money Demand and its determinants in Nepal


1.1 Introduction
According to Keynesian money demand theory considers money as a store in value in addition to a medium of exchange. The store in value function of money signifies that money is an asset in which a person can hold wealth i.e. money is a part of wealth. Keynes combined all assets that were alternatives to money into one category, which he terms ‘bond’. According to him, people either hold money in cash or purchase bonds. Selling or purchasing of bonds depends on market rate of interest. Thus Keynes introduced a new demand function in which demand for money depends on the market rate of interest. This is popularly known as speculative demand for money. On the other hand, he also believe classical money demand function and he says that people hold money for three motives. They are:  


  1. Transaction motive
  2. Precautionary motive
  3. Speculative motive

1. Transaction demand for money
The first motive Keynes considered was transaction motive. According to this motive, money is medium of exchange and individuals hold money fro the use in transaction of goods and services. The amount of money held for transactions would vary positively with the volume of transactions in which the individual engaged. Income was assumed to be a good measure of this volume of transaction and thus transaction demand for money is positively related to the level of income. Symbolically, transaction demand for money is written as;
Mdt = f(Y)…………. (i) and f’ > 0
Where, Mdt = transaction demand for money and Y = level of income.
Equation (i) clearly shows that transaction demand for money is an increasing function of income in Keynesian system. Graphically, it is shown in figure below;

Figure 1.1: Keynesian transaction demand for money and income

Figure 1.1 shows an upward sloping transaction demand for money. The meaning of upward sloping transaction demand for money curve is that there is positive relationship between income and transaction demand for money. It implies that transaction demand for money increases with the increase in income and decreases with the decrease in income.

Some of the key determinants of demand for money specified by Friedman are: 
1. Total wealth, 
2. the division of wealth between human and non-human forms, 
3. The expected rates of return on money and other assets and 
4. Other variables.

The ultimate wealth-holders are households. To them money appears as a durable consumer good. As such the standard theory of demand for consumer goods can be applied to the demand for money. Also, this demand will be a demand for a quantity of real (and not “Merely nominal) money as the wealth-holders are basically interested a certain command over real goods and services through money and not in the nominal amount of it (money) per se.

Money demand and its determinants in Nepal

Major determinants of money demand are stated below:

1. Total wealth:

This is the analogue of the budget constraint in the usual theory of consumer choice. It is the total that must be divided among various forms of assets. In practice, estimates of total wealth are rarely available, more so when total wealth is defined to include not merely non-human or physical wealth but also human wealth, that is, the present value of the expected flow of labor income. So income is generally used as a surrogate for wealth. Income, as we know, includes both property income and labour income.

But to serve as a good proxy for wealth, a longer-term concept of income, like Friedman’s concept of ‘permanent income’, should be used in place of current income. The emphasis on income as a surrogate for wealth, rather than as a measure of the ‘work’ to be done by money, has been claimed by Friedman as the basic conceptual difference between his formulation of the demand for money and the earlier formulations, both neoclassical and Keynesian, concerned with the transactions approach to the demand for money.   

2. The division of wealth between human and non-human forms:

Since total wealth is assumed to include human wealth and institu­tional constraints limit narrowly the conversion of human into non-human wealth or the reverse, Friedman hypothesis es the fraction of total wealth that is in the form of non-human wealth to be an additional important variable. In particular, he hypothesises the demand for money to be a declining function of the aforesaid fraction, as it is much easier to sell or purchase non-human than human wealth.

3. The expected rates of return on money and other assets:

This is the analogue of the prices of a commodity and its substitutes and complements in the theory of consumer demand. The nominal rate of return on money may be zero as on currency or positive as it is on savings deposits, a large part of which is counted as demand deposits, or even negative, if current-account deposits are subject to net service charges. The nominal rate of return on other assets consists of two parts: first, any currently paid yield or cost, such as interest on bonds, dividends on equities and storage costs on physical assets, and second, expected changes in their nominal prices.

It is through the second part (of expected capital gains or losses) that Keynes had introduced his speculative demand for money. Keynes, however, had considered only bonds as the competing non-money asset. Or, more correctly speaking, he had treated bonds as representing all long-term financial assets. Thus interpreted, the really novel and important feature of Friedman’s formulation is the extension of the margin of substitution for money to stocks of (durable) goods. Obviously, for them the expected rate of change of prices (adjusted for storage costs) gives the appropriate rate of return, and this becomes especially important under conditions of inflation or deflation:

4. Other variables:

Besides the above, there may be other variables that affect the utility attached to the services of money relative to those rendered by other assets, and so should be included in the demand function for money. One such variable suggested by Friedman is ‘the degree of economic stability expected to prevail in the future’.
According to him, wealth-holders are likely to attach considerably more value to liquidity when they expect economic conditions to be unstable than when they expect them to be highly stable. However, it is difficult to express this variable quantitatively.
Friedman’s theory of the demand function for money for an individual wealth-holder is summed up symbolically below:

(M/p)d =f(y,w;rm,rb,repe;u)

where M, P, and y have the same meaning as in the foregoing except that they relate to a single wealth-holder; w is the fraction of wealth in non-human form (or, alternatively, the fraction of income derived from property);rm is the expected rate of return on money; rb is the rate of return on fixed-value securities, including expected changes in their prices; re is the expected rate of return on equities, including expected changes in their price; pe is the expected rate of change of prices of goods and hence the expected rate of return on real assets (unadjusted for storage costs); and u is a symbol for whatever variables other than income that may affect the utility attached to the services of money.

Equation (11.5) can be regarded as giving the aggregate demand function for money, with, M, y, and w referring to aggregate magnitudes if we are willing to assume that the amount of money demanded depends merely on the aggregate or average value of y and w and not their distribution among households (and firms). This assumption is commonly made in deriving almost all macro relations from their micro counterparts.

A short report on Fiscal federalism ( Nepal)


CHAPTER I
INTRODUCTION

1.1Introduction
Fiscal federalism is the study of how expenditure side and revenue side are allocated across different layers of the administration. It is concerned with understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government. It constitutes a set of guiding relations between the national and sub-national (vertical) levels of the government. The concepts of fiscal federalism are related to vertical and horizontal fiscal relations.

In the case of Nepal, provincial governments also would be required to increase economic growth and the per capita incomes of their citizens. In the traditional theory of fiscal federalism (e.g. Oates, 1999), the three main areas are (a) welfare gains from decentralization; (b) assignment of resources and responsibilities between different tiers of government; and (c) fiscal instruments for the resolution of vertical and horizontal imbalances.

1.2 Objective of the Paper
The study focuses on the financial implications of the national-level policies, which comprise not only funding and allocation of public and private resources for particular purposes but also non-financial tools such as regulation or norms and standards. This study provides a good example of employing public finance policies and instruments to promote international cooperation as Nepal believes in the so-called “LPG”: liberalization, privatization and globalization. Given its democratic set up with a free press and independent judiciary, Nepal’s movement towards globalization is based on general political consensus and has a bias for human development.

1.3 Major Issue
The analysis brings out the important features of federal fiscal arrangements in Nepal. The analysis highlights a number of shortcomings, which are due not merely to Constitutional arrangements, but also to conventions, methods and working of institutions. The paper attempts to identify the reform areas, both in policies and institutions. Like in most other federations, the system of assignments has resulted in a significant degree of vertical fiscal imbalance.  The wide differences in per capita incomes among the states will have caused severe horizontal fiscal imbalances.  Reforms in the transfer system will have to begin with redefining the scope of National Planning Commissions to avoid the overlap in their roles.  Preferably, the entire transfers should be the responsibility of the Planning Commission should focus on physical infrastructure.

Until the debt market for the States is fully developed, the Planning Commission could also administer loans to finance physical infrastructure.  For poorer States and those located close to international borders, they could even provide loans at concessional rate of interest. The Planning Commission should be made a permanent body with well qualified technical personnel providing information and research base. Another important issue is the extent to which the Centre has been able to effect regional redistribution.  Market based resource allocation can produced severely skewed distribution of incomes across regions, unless the central government undertakes effective measures.  Under the Planned regime, the regional policy of the central government is an important factor determining regional resource allocation.  

1.4 Background of the Study
This  is  particularly  important  in  the  context  of  globalization  as  the  states  with  more  developed markets  and  infrastructure  can  reap  higher  benefits  from  access  to  domestic  and  international markets  and  grow  faster  than  those  with  less  developed  markets  and  infrastructure. It is also important to regulate the competition, provide a negotiating platform and resolve inter-state and centre-state conflicts.

1.5 Literature review
Since Tiebout’ article “A pure theory of local expenditure” was published, the field of fiscal federalism has been substantially developed and many articles on fiscal decentralization have been contributed. In Oates’ (2005) terminology, the “first generation theory” of fiscal federalism was well established in public finance. Tiebout (1956) argued that fiscal decentralization would result in the improvement of production efficiency by altering perfect mobility of citizens and overcome the free rider problem in public goods. Musgrave (1959) in his text book on “Public Finance” described the role of the government sector in terms of correcting the market failures. When private markets failed to supply such goods then government should introduce policy measures correcting such failures in the field of allocation, macroeconomic stabilization, and income redistribution. He also emphasized that allocation efficiency will be achieved when local tastes and preferences have been met. In addition Oates (1972) argued that the regions have different tastes and preferences for public goods so that local government will provide better services for their citizens because they have better information than central government about the preferences of the local citizens. Therefore, Oates’ decentralization theorem states that economic efficiency will be achieved through the decentralized provision of public goods.

From the more recent discussion on public economics literature one can conclude that the central government should be responsible for national policy and provide efficient levels of national public goods. The sub-national governments’ role is the provision of efficient levels of regional and local public goods for their constituencies. With a proper assignment and the necessary fiscal tools at their disposal, regional and local agent can implement welfare maximizing policies (Oates, 2005). Hence, the analysis will be focused on the intergovernmental relations in order to address the problem and to meet the demand of the study.

From a polit-economic view the public sector bureaucrats show a rent seeking behaviour. Oates (2005) argues that new literature on fiscal federalism draws on two basic sources, that are a) public choice and political economy, which focus on political processes and behaviour of political agents, and b) information problems (asymmetric information). According to this view the assessment of fiscal decentralization will have some different perspectives. For instance in case of developing and transition countries, in a setting of asymmetric information and control, incentives for budget maximizing behaviour of the political agents are very strong. The main principle of the public-choice approach is that public decision makers are utility maximizers with their own objective functions. Niskanen (1971) has constructed a model, which explained the budget maximizing behaviour of the public agents. Niskanen listed a certain number of variables in their utility functions such as salary, reputation, power and patronage. Brennan and Buchanan (1980) extended this view and stated that the public sector is a monopolistic agent. Therefore fiscal decentralization will be a mechanism to constraint the expansionary tendency of the government (“Leviathan”) through the competition between regional and local governments.

Cremer, Estache and Seabright (1996) argue that central government fails to get information about the local tastes and preferences. Hence, fiscal decentralization will have a positive impact because it allows regional and local government to provide an efficient supply of local public goods for their constituents. Qian and Weingast (1997) state that decentralization is the mechanism for controlling over intrusive and expansive tendencies of the public sector and supports effective operation of the private markets. So, from the public choice and political economy perspective, the fiscal decentralization will constrain the budget expansion through competition and enhance controlling and accountability, which results in an efficient supply of regional and local public goods and support the private markets. However, local political agents are keen to expand their programs and expenditures beyond the mean and also try to increase local public goods by the expense of other jurisdictions. Rodden (2003) argues that it is a matter of fact, which form fiscal decentralization takes. If fiscal decentralization relies on own tax sources, smaller jurisdictions result and if transfers are financed by the central government an overall increase in the budget occurs. The public choice perspective does not examine the structure of fiscal institutions, which is an important component for fiscal decentralization and the effect of fiscal decentralization will certainly depend on the fiscal institutional structure.

From the economic and political science perspective, the fiscal decentralization has many benefits, however, decentralization is not a panacea, and it also does have 16 costs. The decentralization can result in the loss of economies of scale and control over the scarce resources; inefficiency in service delivery and complexity in policy coordination may happen if decentralization is implemented in a wrong way (World Bank, 2007).

Alexis de Tocqueville more than a century ago observed that, “The federal system was created with the intention of combining the different advantages which result from the magnitude and littleness of nations” (1980, Vol. 1, p. 163).  The gains from the magnitude and littleness can be realized only when the functions of different levels of governments and various units within each of the levels are clearly specified according to their comparative advantage.  The system allows reaping gains from the common market and economies of scale in the provision of national public goods. This is achieved by providing of public services according to the diversified preferences of people.  Similarly, Bird (2000) makes a distinction between fiscal federalism and federal finance. In his formulation, under fiscal federalism everything -boundaries, assignments, and the transfers is malleable, under federal finance these must be taken to be fixed at some earlier (constitutional) stage and not open to further change under normal circumstances. As Stated by Wallace Oates, “...the term federalism for the economist is not to be understood in a narrow constitutional sense.  In economic terms all governmental systems are more or less federal: even in a formally unitary system” (Italics in the original; Oates, 1977; p. 4).



CHAPTER II
SUBJECT MATTER

2.1 Overview of Nepal’s federal structures and fiscal situation
Fiscal federalism can potentially provide the framework for unlocking this potential by ensuring peace and harmony, and providing a means of expression for ethnic and regional preferences and priorities. Fiscal federalism is an idea which asserts that in a multi-tier structure of governance, central and sub-national governments work as economic players, competing, cooperating and coordinating with each other within a set of rules to promote the welfare of the citizens by equitable and efficient delivery of services.

In the case of Nepal, provincial governments also would be required to increase economic growth and the per capita incomes of their citizens. In the traditional theory of fiscal federalism (e.g. Oates, 1999), the three main areas are (a) welfare gains from decentralization; (b) assignment of resources and responsibilities between different tiers of government; and (c) fiscal instruments for the resolution of vertical and horizontal imbalances.  



At the moment, the central government controls more than 97 percent public revenue and expenditure. The extremely centralized government’s finance is the principal hindrance to economic development because the public sector economy contributes more than one third to gross domestic product (GDP) in Nepal. Government finance matters in national economy.



CHAPTER III
CONCLUSIONS AND RECOMMENDATIONS

3.1 Conclusions
This paper has sought to examine several dimensions of economic reform in Nepal, in the context of the country’s federal system and of globalization. In our analysis, we have explicitly recognized that the national government has sub national governments below it, and that all these layers of government simultaneously interact with foreign governments and corporations in a global economy. We have been able to identify some areas in which the states may be able to achieve positive reforms acting independently, and other areas where coordination between the central and the state governments in designing and implementing reform policies may be more appropriate. Furthermore, we have highlighted the challenges of greater openness to the world economy, and of growing regional disparities. The former requires urgent attention to the financial position of the government in particular, as well as of the financial sector as a whole.

3.2 Recommendations
There are a variety of motivations for having a federal form of governance.  In some cases different countries come together to form a confederation for a common interest which may eventually evolve as a federation to reap the gains from common security and common market inside in the country and globally as well.  In other cases, the dissatisfaction with the existing centralized administrations in dealing with economic, social, political and linguistic diversities and a feeling of exclusion in terms of the opportunities can be a motivating factor.  In a rapidly growing economy where employment and income earning opportunities expand; the feeling of being excluded is less.

In the case of Nepal, the motivation for adopting federal system of governance comes from both relatively slow growing economy where opportunities do not expand fast enough and the feeling of exclusion from various groups.  It is hoped that adoption of federal governance will help to accelerate the pace of economic growth to expand the opportunities.  It is necessary to underline the fact that calibrating policies and creating institutions to accelerate the inclusive development of the economy must complement the creation of federal governance system for the stability and sustainability of the federation.   







REFERENCES

Budhatoki, Nandakaji (2012), “Economics of Fiscal Federalism in Nepal”, IIDS Policy Brief No.4.

Tocqueville, Alexis de (1945), Democracy in America, New York: Vintage Books Random House: first published 1838.

Bird, Richard, M (2000), “Fiscal Decentralization and Competitive Governments” in Galeotti.

Rao, M. Govinda, H. K. Amar Nath and B. P. Vani (2004), Rural Fiscal Decentralisation in Karnataka”, in G. Sethi (ed) Fiscal Decentralization to Local Governments, Oxford University Press, New Delhi.

Impact of Globalization and Liberalization

Globalization
Globalization refers to an advance stage of development where capital, technology, labor, raw materials, information and transportation, distribution and marketing are integrated or interdependent on a global scale.
Economic liberalization and globalization are closely linked. It is important to take these terms interchangeably. Basically it is liberalization policy which enables the growing globalization process. Thus economic liberalization generally refers to policy be defined as the process of increasing economic integration between or among countries leading to the emergence of a global market place or a single world market in every aspect of economic activities: production, consumption, exchange and distribution. Thus globalization may be seen as a major driving force of global economic integration and has the following main features:
§  Internationalization of production with very fast changes in the structure of production.
§  Liberalization and expansion of world trade in goods and services.
§  Unprecedented expansion of international financial flows supported by the latest technological advances.

Types of Economic Globalization
§  Industrial globalization
§  Financial globalization
§  Globalization in consumption and production

Impacts of economic globalization
Globalization enhances the share of international exchanges in the world economy.
§  Increased standard of living
§  Access to new markets
§  Widening disparity in incomes
§  Decreased employment

The main positive impacts of globalization are:
§  Industrial trans-nationalization
§  Financial
§  Economic
§  Political
§  Informational
§  Cultural
§  Ecological
§  Social
§  Transportation

Challenges and potential opportunities of financial globalization can be explained through following diagram
§  Financial globalization
§  Challenges
§  Competition
§  Capital flights
§  Money laundering
§  Financial voltality
§  Opportunities
§  Foreign investment
§  Growth
§  Market

Effects of globalization in the world economy
The volume of world trade has grown at a faster rate than the volume of world output
§  FDI has been playing an important role in the global economy
§  Emergence of multilateral trading systems
§  Domestic firms are required to enhance the production and distribution capabilities
§  Internationalization of production: multinational origin of product components, services and capital
§  Increased movement of workers across national boundries
§  Transfer of technology and other intellectual property internationally
§  Substantial interdependence of the various dimensions such as trade, direct investment, technology transfer, capital movements, migration, etc.
§  International competition in global market (service, labor, financial and product markets)
§  Increased role of international organizations such as WTO, WIPO and IMF etc.

Faster growth, reduced poverty and inequality through factor and product price equalization, and risk diversification are some positive aspects of globalization. However, LDCs economies have been more dependent. They face the problem of external shocks and they lost benefits of market integration.

Conclusion
Globalization underscores the need for state co-ordination. In order to foster the well-being of its citizens amidst the globally competitive activities of private corporations, the state should provide economic infrastructure, develop globally-competitive human capital and protect the environment. The states in developing countries should also design and implement policies suitable for their development needs, for example, (limited) protection of domestic industries under WTO rules.

Liberalization
Liberalization means freeing the prices, trade and entry to markets from state control while establishing the economy. It is a program of changes in the directions of moving towards free-market economy. This normally includes the reduction of direct controls on both internal and international transactions, and a shift towards relying on the price mechanism to co-ordinate economic activities. Less use is made of licenses, permits, quotas and price controls, and there is more reliance on price to clear the market.
The beginning of liberalization was elimination of quantitative restrictions and massive reduction in tariffs. We find liberalization in different policies and programs now a day.
§  Macro-stabilization policies
§  Trade liberalization
§  Liberalization in foreign investment
§  Financial sector reform
Economic liberalization has been a policy issue in developing countries for various reasons such as,
§  Macroeconomic stability
§  Poverty reduction
§  Efficiency and expansion of market
§  Comparative cost advantage and specialization
The positive effects of liberalization are
§  Massive poverty reduction
§  Macroeconomic stability increasing growth rate
§  Increase in competitiveness
§  Specialization
§  Enhances efficiency
Liberalized markets are supposed to increase specialization. Financial liberalization improves functioning of financial sectors like increasing funds, risk diversification and investment.

Money Demand and its determinants in Nepal

1.1 Introduction According to Keynesian money demand theory considers money as a store in value in addition to a medium of exchange. Th...