When economy faces downturn, the level of output and employment declines causing a reduction in total saving in the banking system. Additionally, the number of defaults on loans increases, which impairs public confidence on banks leading to bank run. With increasing defaults and bank run, the total money supply shrinks. To understand this phenomenon, we need to explain how we measure total money supply. The simplest measure include total currency on circulation and deposits/ credits created by banks. Under fractional reserve banking system, when someone deposits his/her money into the bank, all of it is not held as reserve by the bank. The bank keeps a fraction (which is generally determined by the central bank) of the money as reserve and lend the rest by creating deposit into the borrower’s account. A fraction of the unwithdrawn money from the borrower’s account is again held as the reserve and the rest is lent out. This process continues and there is an addition to the existing stock of money.
As total money supply shrinks during times of economic crises, monetarists prescribe expansion of money supply. However, the monetary expansion still follows the constant growth trend which it would follow during normal times. To elaborate, let us suppose that total money supply in the economy during Year 1 is equal to 100 rupees and the constant growth rate which monetarism advocates for is 10 percent. The total supply of money in Year 2 should amount to 110 rupees during normal times. But, if the economy faces recession during Year 1 and the money supply plummets to 80 rupees, for money supply to reach targeted 110 rupees in Year 2, it has to be increased by 37.5 percent.
Nepal is almost certain to face reduction in supply of money because of economic downturn owing to COVID-19 pandemic and measures undertake to contain it. The savings are bound to fall and cases of defaults will possibly rise, which will reduce banks’ ability to create deposits/ money. All in all, there will be a reduction in supply of money in the economy. A reduction in money supply will further lead to reduction in economic activities worsening the economic crisis. Therefore, going by monetarists’ agenda, Nepal Rastra Bank, the central bank of Nepal should opt for expansionary monetary. Here, expansionary monetary policy does not mean expanding beyond course of monetary growth which would have been during normal times. The monetary policy should fill the deficit caused due to shrinkage of money supply in the economy, thus filling the gap between demand and supply of money. This will preempt shortage of money supply in the economy and prevent the economy from downward spiral. With enough money supply and sufficient liquidity in the economic system, we can move towards the path of quick recovery.