i

REPORT ON INFLATION OF NEPAL

A Report Submitted to:

MR. Homnath Poudel

Faculty of Management

Tribhuwan University

Kritipur, Kathmandu

In Partial Fulfillment for the course of Macroeconomics Seminar

& Report writing

Submitted By: Arti Kumari Ray

BBA 2nd semester
Symbol No: 32548/21
KCMIT College
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LETTER OF RECOMMENDATION

This thesis entitled "INFLATION OF NEPAL "has been prepared by Ms.

Arti Kumari Ray under my supervision and guidance. I hereby
recommend this report to the examination by the Thesis Committee as a
partial fulfillment of the requirements for the degree of Bachelors of
Business Administration.

…………………………….
Prof. MR. Homnath Poudel
(Report Supervisor)

Facilitator for Macroeconomics

Faculty of Management

KCMIT Basuki Marga, Kathmandu

Date:
 2

APPROVAL LETTER

This report entitled "INFLATION OF NEPAL" has been evaluated and

accepted as partial fulfillment of the requirements for the requirement of
Bachelor's Degree in Business Administration. The report has been
evaluated by

(Thesis/Report Committee)

……………………………………..
Prof. MR. Homnath Poudel
(Thesis/Report supervisor)

………………………………………
(External Examiner)

Date:
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ACKNOWLEDGEMENT

It is my immense pleasure for getting the opportunity to present the project of

Bachelor of Business Administration (BBA), 2nd Semester, under the subject
ECO-212; Macroeconomics for Business, with the basic purpose of fulfilling the
requirement of the degree of BBA and has the partial exposure of the theoretical
knowledge gained. This report aims at research on the topic of "Inflation Of
Nepal".
I have taken immense effort in this project completion. However, it would not have
been possible without the kind support and help of my teachers.
I am very thankful to our teacher Mr. Homnath Poudel for providing me an
opportunity to perform the project and all support and leadership, which made me,
finish the project duly. His constant guidance and willingness to share his vast
knowledge made me understand this project and its importance. I am really
thankful to him for providing such excellent support and guidance, despite having
a busy schedule.
I am also thankful to my college "KCMIT" as it always encourages the student to
put the theoretical knowledge of students into practice. This project would not have
been possible without the help and support of our college.

Yours sincerely,

Arti Kumari Ray

BBA 2nd Semester
KCMIT
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TABLE OF CONTENT

Topic No. Topic Name Page No.

Title Page

LETTER OF RECOMMENDATION ii

Approval Letter iii

Acknowledgement Iv

Table of Content V

CHAPTER ONE: INTRODUCTION

1.1 Introduction 6

1.2 Objective of study 7

1.3 Sources of Data 8

1.4 Importance of study 8

CHAPTER TWO : REVIEW OF LITERATURE

2.1 literature of Review 9

Review of National Literature
2.2 9

2.3 Review of International Literature 12

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CHAPTER THREE: PRESENTATION &

ANALYSIS

3.1 Weighted CPI of Nepal 18

3.1.1 Tables 19
3.2 Analysis

CHAPTER FOUR: CONCLUSIONS &

RECOMMENDATION

4.1 Conclusions 23

4.2 Recommendation 24

REFERENCES
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CHAPTER ONE : INTRODUCTION

1.1 Inflation refers to a sustained increase in the general price level of goods and
services over a period of time, leading to a decrease in the purchasing power of
money. In Nepal, inflation has been a persistent challenge for several decades, with
a variety of factors contributing to its occurrence.

One of the major drivers of inflation in Nepal has been the country's heavy
dependence on imports, particularly of essential commodities such as fuel, food,
and raw materials. The increase in the prices of these items in the international
market, coupled with a weak domestic currency, has led to a rise in their cost for
consumers and businesses within Nepal.

In addition, structural factors such as supply-side constraints, inefficient market

systems, and a lack of investment in infrastructure and technology have also
contributed to inflation. These factors have resulted in a limited supply of goods
and services, which has driven up their prices.

Another factor contributing to inflation in Nepal is monetary policy. The country's

central bank, the Nepal Rastra Bank, has historically pursued an expansionary
monetary policy, with high levels of government borrowing and loose credit
conditions leading to an increase in the money supply. This has contributed to
inflationary pressures, particularly in the short term.

Overall, inflation remains a significant challenge for Nepal, with a range of factors
contributing to its occurrence. Addressing these issues will require a
comprehensive approach, including measures to increase productivity, improve
infrastructure and technology, and pursue more effective monetary and fiscal
policies.

.Causes of Inflation in Nepal

Several factors contribute to inflation in Nepal. One of the primary causes is the
rise in food prices. Nepal is an agricultural country, and most of the population
depends on agriculture for their livelihood. Therefore, any increase in food prices
affects a significant portion of the population. The shortage of supply due to
droughts, floods, and other natural disasters also contributes to food price inflation.
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Another significant cause of inflation in Nepal is the increase in oil prices. Nepal
imports most of its oil and gas from neighboring countries like India, and any rise
in oil prices on the international market leads to an increase in the cost of
transportation and production. This, in turn, leads to an increase in the prices of
goods and services.

.Effects of Inflation in Nepal

Inflation has several negative effects on the Nepalese economy. One of the most
significant impacts is the erosion of the purchasing power of the Nepalese
currency. As the prices of goods and services increase, the value of money
decreases, leading to a reduction in the standard of living for the average Nepalese
citizen.

Another effect of inflation is the reduction in foreign investment. Inflation reduces

the competitiveness of the Nepalese economy, making it less attractive for foreign
investors. This reduction in investment leads to slower economic growth and
development.

.Solutions to Inflation in Nepal

To address inflation in Nepal, the government needs to implement several

measures. One such measure is to increase agricultural productivity by providing
farmers with improved agricultural technology and infrastructure. This will lead to
increased food production, leading to a reduction in food prices.

Another solution is to diversify the economy by reducing reliance on imported

goods and services. This can be achieved by promoting domestic industries and
increasing local production.

1.2 Objective of the study

The Objective of this Report can be summarized into following points:

 To study about inflation of Nepal
 To know about inflation of Nepal
 To analyze about inflation of Nepal
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1.3 Source Of Data

In short, the sources of data are physical or digital places where information is
stored in a data table, data object, or some other storage format .We have collected
data from the both primary sources and secondary sources. Under secondary
method, we collected the information visiting the various website and scholar
journal, articles, books which turn out to be vital.

1.4 Importance of study

The study of inflation in Nepal is essential for several reasons. Firstly, inflation
affects the living standards of the Nepalese people, and understanding its causes
and effects can help policymakers develop strategies to mitigate its impact on the
population. It is crucial to understand the different factors that contribute to
inflation, such as food and oil prices, and how they affect the Nepalese economy.
By analyzing inflation, policymakers can develop policies that target the root
causes of inflation, leading to long-term stability and growth.

Secondly, inflation can have a significant impact on foreign investment in Nepal. If

inflation is high, foreign investors may be discouraged from investing in the
country due to increased uncertainty and reduced competitiveness. Therefore,
studying inflation is critical for policymakers to develop strategies that promote
economic growth and attract foreign investment.

Lastly, inflation affects the government's ability to finance public projects and
programs. If inflation is high, the government may have to pay higher interest rates
on borrowed funds, reducing the amount of resources available for public projects.
Therefore, understanding inflation is crucial for the government to develop
strategies that promote fiscal stability and sustainability.

In conclusion, the study of inflation in Nepal is essential for policymakers to develop strategies
that promote economic growth and stability, attract foreign investment, and ensure fiscal
sustainability. By understanding the root causes of inflation and its effects on the economy,
policymakers can develop effective policies that promote long-term stability and growth.
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CHAPTER TWO: REVIEW OF LITERATURE

2.1 Ever since Richard Cantillon wrote his Essay on the Nature of Trade in General
in the early 18th century, economists have known that inflation does not work its
way throughout the economy uniformly. Some prices go up first. Others go up, but
only after a while. Some might hardly go up at all. This plausibly affects the
economy’s structure of relative prices. Since relative prices guide resource
allocation, inflation can result in destroyed wealth in the form of mistakes in
production and consumption.
However, Cantillon effects have proven quite resistant to empirical estimation. The
few times economists go looking for them, they seem to be small and imprecisely
estimated. This doesn’t mean we should rule out the potential for Cantillon effects
entirely. But it does put them into perspective. Perhaps this damning theoretical
indictment of inflation isn’t so forceful in practice.

2.2 Review Of National Literature

Byanjanakr (2020) examined the determinants of inflation in Nepal using time series
data from 1975-2018 by applying the ARDL approach to cointegration the price level
is dependent variable and Indian inflation, money supply (M2), government deficit,
nominal exchange rate and crude oil price are independent variables. The study found
that Indian inflation is the most significant factor influencing the Nepalese inflation.
Similarly, the exchange and government deficit have positive impact on prices in both
the long-run and short-run. The Study suggested that government deficit causes an
increase in money supply, which exerts pressure on price. The study made
recommendation to establish mechanism for monitoring price development in Indian
market.

Paudyal (2014) Examined the determinants of inflation in Nepal using time series data
from 1975-2011 by applying Wickens-Breush single equation error correction model.
The variables considered are budget deficits, Indian prices, broad money supply,
exchange rate and real GDP. The study found that all variables considered are
significant in long run implying that these variables are the determinants of inflation 22
in Nepal. However, only budget deficit, money supply and Indian prices cause inflation
in the short run. The results are consistent with monetarists’ hypothesis of money
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matters and inflationary gap theory of Keynesian as well as supply constraints approach
to inflation.

Chaudhary and Xiumin (2018) examined analysis of the determinants of inflation in

Nepal using time series data from 1975-2016 by applying ordinary least square multiple
regression model. The variables considered for the study is limited to the use of broad
money supply, real GDP, Indian prices. The study suggested that all variables
considered are significant in long run implying that these variables are the determinants
of inflation in Nepal. The results are consistent with monetary theory. The money
supply and Indian prices cause inflation in the long-run based on an Ordinary Least
Squares regression model.

Koirala (2008) Invested inflation expectations in Nepal using 33 annual observations

of actual inflation from 1973 to 2006. The study stated that there is a significant positive
relationship between inflation and inflation expectations in Nepal, one percent increase
in inflation expectations has 0.83 percent impact on contemporaneous inflation. The
forecast ability of inflation proxies by one period lagged inflation. The forecast of the
model has been examined on the basis of minimum root squared error (RMSE).

It was suggested that it is desirable for the policy makers to consider the impact of
inflation expectations while formulating monetary policy anchor inflationary
expectations of economic agents.

Pandey (2005) revealed that domestic prices are influenced by both the monetary and
structural factors. Reviewing the price movement during the period 1973-2004 by using
Error Correction model (ECM) for the study, it was revealed that out of 33 years in the
review, 12 years witnessed the double digit inflation. Only in one year (1975/76),
inflation was found to be negative.

The empirical findings confirmed that Indian Prices, money supply and exchange rate
changes are the most significant determinants of inflation in Nepal. Moreover, 23
inflation in Nepal has long run relationship with money supply, Indian WPI,
government expenditure, real GDP, and exchange rate. It was suggested that in order to
control inflation in Nepal, Nepal needs to adopt a flexible exchange regime, monetary
policy needs to set a single goal of price stability, and follow effective supply
management system.

Neupane (1992) examined the monetarist and structuralism hypothesis to evaluate the
causes of inflation in Nepal. The regression result based on monetarist approach
provided a fair explanation of inflationary process. Based on this model, one year
lagged money supply and cost of holding real balances are the important explanatory
variables to explain the causes of inflation in Nepal. Besides, the results of the
 11

structuralism approach suggested that a shortfall in commodity producing sectors,

increasing import prices and government budget deficit and slow growth of agricultural
and industrial production inflationary expectations.

The findings suggested that monetary policy is an important instrument to control

inflation. A policy of increasing money supply in line with growth of per capita GDP
will help control inflation and provided a much broader perspective of the complexities
of the inflationary process in Nepal.

Gyanwaly (2012) examined the direction of causality between money, price and
income in Asian countries namely- Nepal, India, Sri Lanka, Myanmar and Korea using
the annual data of the period 1964-2011. Bivariate Granger causality test was performed
for both non co-integrated and co-integrated variables using conventional Granger F
test and ECM models respectively.

The study concluded money supply is an endogenous variable in all the countries,
though the extent of endogeneity in term of price and income variable slightly differs
from one to another. Money causes both price and income and is receiving the feedback
effects either from price or income or both.

Pant (1988) tried to analyze inflationary trends of some Asian countries including Nepal
taking the periods of 1955-1985 using OLS method, and DW test. The rate of inflation
has been taken as the dependent variable whereas money supply, real income, imports,
exports, expected change in price were taken as independent 24 variable. Since, the data
on exports and import price indices were not available, the unit value of export and unit
value of import of India were considered as proxy for.

The empirical findings suggested that money supply, real income, export and expected
change in prices have positive relationship with the rate of inflation whereas import has
negative relationship with the rate of inflation.

Pradhan (1977) expressed the view that money supply is one of the important
determinants of price. By increasing the money income with the public, it influences
the demand for goods and services. If foods demanded are wholly domestic goods and
no substitutes are available from outside the territory i.e. if the country has a very rigid
import control regime, then of course money will be a very significant factor in
determining the price level.

However, Nepal is an open economy with virtually no restrictions on the movement on

most of the products across the border. At the same time substitute to almost all
domestic product are easily available from India. Thus, the rise in the prices of domestic
product would quickly invite substitutes of the goods from India restricting the rising
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trend of domestic prices. The excessive money supply affects more on the balance of
payments as Nepalese economy is intimately linked with the Indian economy.

NRB (2017) has explored the optimal level of inflation for Nepal based on the data of
the period from 1978- 2016. This study used real GDP per capita growth is a dependent
variable and inflation, inflation squared. Saving to GDP, life expectancy at birth, trade
openness, exchange rate overvaluation and lagged real GDP per capita are the
explanatory variables. The results suggest that there exists a threshold effect of
inflation. The Ordinary Least Squares method estimates the turning point of inflation to
be 6.25 percent while that of the Hansen (2000) method shows the threshold level to be
6.40 percent. The maximum impact on growth associated with the turning point, and at
the mean levels of other explanatory variables is quite high at 4.59 percent. The results
suggest that Nepal should adopt an inflation target range around the computed optimal
inflation rate to lower the inflation expectation and enhance economic growth.

25 IMF (2014) estimated the determinants of Nepalese inflation on the monthly series
of Nepal's CPI, broad money, a nominal effective exchange rate (NEER), and Indian
CPI using OLS. The coefficient of broad money supply and Indian inflation was 0.12
and 0.45 percent respectively; indicating a 1 percent increase in broad money supply
will cause Nepalese inflation to rise by 0.12 percent whereas such an increase in Indian
CPI will increase Nepalese inflation by 0.45 percent.

2.3 Review of International Literature

Khatun and Ahamad (2012) Investigated major determining factors of inflationary

trends In Bangladesh during the period FY1981 to FY2009. An unrestricted
errorcorrection Model based on the Autoregressive Distributed Lag (ARDL) bounds
F-test has been employed to find out the short-run and long-run elasticity of the
determinants of inflation. The empirical results revealed that domestic rice production
affects inflation negatively in the short-run to a significant extent. Conversely,
domestic petroleum price and broad money (M2) supply have a low but positive
impact on inflationary trends. The study suggested that increased domestic rice 16
production and effective fiscal-monetary integration are the crucial policy options to
curb the inflationary pressure in Bangladesh.

McCandless and Weber (1995) looked at inflation in 110 countries during a 30-year
period. The study concluded that inflation and monetary aggregates are positively
correlated in the long run. However, as the time horizon shortens, the correlation falls.
 13

Campillo and Miron (1996) Examine the determinants of inflation across 62 countries
over the period 1973 - 1994 by considering the distaste for inflation, optimal tax
considerations, time consistency issues, distortionary non-inflationary policies and
other factors as important determinants of inflation. Inflation rate is measured by the
Consumer Price Index (CPI). The authors' have adopted Ordinary Least Squares
(OLS) technique with standard error, estimated by White (1980) procedure. They
found economic fundamentals like economic openness and optimal tax considerations
are relatively important determinants of inflation whereas institutional arrangements
like central bank independence or exchange rate mechanisms are relatively less
important.

Qayyam (2006) investigated the relation between money, inflation and growth in
Pakistan and tested the validity of monetarist stance that inflation is a monetary
phenomenon by using data from F.Y. 1960 to 2005. This study found that there is
positive association between money growth and inflation in Pakistan. Based on the
research question that to investigate the linkage between money supply, income and
growth; researcher used the linear form of quantity theory of money. The study found
that money growth this year affects rate of inflation in the next year in addition study
found money supply is the key factor that affects the inflation. Money supply growth
has 90 percent explanatory power. The research revealed that there is proportional
relationship between money supply over the output growth and the velocity growth
and hence the research also conform that monetarist proposition that, money supply is
the main factor that contributes towards the inflation in Pakistan.

Lim and Sek (2015) conducted research on an examination on the determinants of

inflation for the period from 1970 to 2011. An error correction model based on the
autoregressive distributed lag (ARDL) modeling has been used to explain the short 17
run and long run impacts of each variable on inflation. The result revealed that GDP
growth and imports of goods and services have the significant long run impact on
inflation in low inflation countries. Result also indicated that money supply, national
expenditure and GDP growth are the determinants of inflation which impose long run
impact on inflation in high inflation countries. In the short run likewise, none of the
variables is found to be significant determinants in high inflation countries. However,
money supply, imports of goods and services and GDP growth has significant
relationship with inflation in low inflation countries.

Hossin (2015) has explored the relationship between inflation and economic growth in
the context of Bangladesh. The study used the annual data set of real GDP and GDP
Deflator for the period of 1961 to 2013. The researcher applied the cointegration test,
error correlation models and Granger Causality test to analyze the relationship
between inflation and growth. The result suggested that there exists a statistically
 14

significant long-run negative relationship between inflation and economic growth.

Similarly, there exists a statistically significant long –run positive causality running
from GDP to GDP Deflator. In addition, the study suggested that economic growth
affects inflation positively but when increase in the rate of inflation goes beyond the
threshold inflation level then inflation affects economic growth negatively.

Nwachukwu (2014) examined the “Error Correction Model Analysis of Determinants

of Inflation in Nigeria”, for the Period 1970- 2013, employing Error Correction
technique of econometric analysis. The variables used were GDP, exchange rate,
inflation rate, domestic credit growth rate, money supply, government expenditure.

The test of both the unit root and co-integration revealed that there is a long
relationship between the variables while the Granger causality test revealed a
unidirectional relation between the variables and inflation. However, the VECM test
revealed that inflation, GDP and exchange rate are negatively related and positively
related to broad money supply (M2) and domestic credit. It was recommended that the
Central Bank of Nigeria should balance its control instruments to achieve
macroeconomic stabilization and development, money supply should be controlled to
ensure high employment, and interest rate should be liberalized to control price.

Hussain and Malik (2011) examined nexus between inflation and economic growth in
the context of Pakistan economy. They used the annual data for the period of
19602006 and applied causality test and the Error Correlation Model (ECM) to
examine the relationship between inflation and growth. The study found that the
unidirectional causality between inflation and growth i.e. inflation is causing growth
but not vice versa. Similarly, inflation is positively related with economic growth in
Pakistan and vice versa. Finally, they found that 9 percent threshold level for Pakistan
above which inflation starts the lower economic growth. The study suggested that
Pakistan must need inflation in single digit for economic growth.

Patnaik (2010) aimed at empirically identifying the determinants of Inflation in India.

She concluded that inflation in India is majorly demand pull inflation. This is because
both the money supply and the index of industrial production (IIP) represent the
existing demand in the economy. However, the supply side factors which come via
the imports also influence the inflation in the short run. Moreover, the short run
duration impact of the imports shows that the external factors are not the major factors
relationship between the variables between CPI, IIP, Reserve Money(RM), and import
price.

Munene and Misati (2015) estimated second round effects and pass through of food
prices to inflation In Kenya. Based on monthly data covering the period 1997 to 2012,
 15

the paper attempts to fill the gap by examining the relationship between food prices
and inflation using gap models and Phillips curve approaches.

The study found that there is a presence of second round effects from food prices to
inflation while estimations of the Phillips curve suggest a domestic food price-pass
through of 0.49 to overall inflation and 0.38 to nonfood-non fuel inflation. The world
food prices pass-through to overall inflation and non-food non-fuel inflation are
estimated at 0.09 and 0.08 respectively. The study recommended usage of headline
inflation to estimate trend of inflation and while monetary policy is very critical in
anchoring inflationary expectations, there is mutual gain from a supportive fiscal
policy in addressing supply side shocks and also suggested that core measure of
inflation that excludes food inflation may not be appropriate in estimating underlying
inflationary pressure.

Ratnasiri (2006) examined the main determinants of inflation in Sri Lanka over the
period 1980-2005 using Vector Autoregressive analysis. The variables undertaken for
the purpose were money supply, rice price, exchange rates and Colombo consumer
price index.

The result indicated that money supply growth and rice price increases are the main
determinants of inflation in Sri Lanka in the long run. In contrast, it is evident that
exchange rate depreciation and output gap have no statistically significant effect on
inflation. In the short run, rice price is the most important variable as it is a totally
endogenous variable. However, money growth and exchange rate are not so important
variables as they are weakly exogenous in the adjustment process. Output gap does
not have a statistically significant effect on inflation in both the long run and the short
run. The study concluded that the identification of determinants of inflation and
forecasting accurate inflation are vital for the economic agents and facilitates the
central bank to conduct its monetary policy efficiently and effectively. The estimation
results pointed to two policy considerations. First, money supply is to be maintained
at desired level and also if the supply of rice can be raised the inflation will come
down.

Rami (2010) examined the relationship between money, price and output using pair
wise Granger causality test on annual data of the Indian economy covering a period
from 1951 to 2005. Lag length is selected using standard critera-LR, FPE,AIC,SC and
HQ through VAR estimation.

The study revealed that the relationship between money, price and output is one of the
most debated issues among different schools of thought of economics particularly
between the Monetarists and Keynesians. The Monetarists argue that money
influences the prices and the output, whereas the Keynesians argue that money does
 16

not influence the same. Direction of causality among these three and selection of
appropriate lag length are widely debated issues in the literature. The results strongly
support the monetarists view and partially supports the Keynesian view. However,
these relationships are sensitive to the lag length selections.

Aydin (2017 has investigated the influence of inflation on economic growth for the
Organization of Islamic Cooperation (D-8 countries: Bangladesh, Egypt, Indonesia,
20 Iran, Malaysia, Nigeria, Pakistan and Turkey) by using the data from 1971- 2014.
The data set was created by calculating the five-year averages of the variables used in
the study in order to make the use of the GMM estimator valid and ensure its
consistence. The study used the dynamic panel threshold model to estimate the
optimal level of inflation for D-8 countries. In this study, the researcher used real
GDP per capita growth as independent variable and inflation rate as core explanatory
variable. Similarly, the lagged value of GDP per capita, the gross capital formation as
a share of GDP (investment), population growth rate (dpop), initial income level
(initial) measured as the log of GDP per capita of the previous period, openness
measured as the annual growth rate of export and annual percentage change in terms
of trade (dtot) were used as other control variables.

The study shows that there is non-linear relationship between growth rate and
inflation. Further, study found that the threshold level of inflation for these countries
is 12.88 percent

Where inflation rate above this threshold level negatively influences economic growth
and an inflation rate under this threshold level positively influences economic growth.
Similarly, this study does not found any causality relationship between inflation and
economic growth. It just shows the existence of relationship. This study suggested that
political and economic decision-makers in these economies should not disregard the
concept of threshold within the framework of monetary policy while determining the
target inflation rate.

Loi and Abou-Zaid (2016) have examined the threshold level of inflation in the US by
using the data set for the period of 1960-2011. They used real GDP growth as the
dependent variable where as inflation was the core explanatory variable. Investment
growth, gross fixed capital formation, population acceleration, growth of openness of
the economy, money supply growth were used as other control variables. They
employed ADF tests for stationary of the variables and found that all variables are
stationary in first difference. Similarly, this study performed Granger causality test
and result shows that only inflation does Granger cause to real GDP. The study used
Threshold model which was developed by (Khan & Senhadji, 2001) to estimate
threshold level of inflation and found that the threshold level of inflation in the US is
 17

between 0 to 1.5 percent quarterly. Above that threshold level, inflation has 21
significant negative effect on real GDP growth, while below the threshold level, the
effect of inflation on real GDP growth is positive. Similarly, to check the sensitivity of
the model this study also employed Two-Stage Least Square (2SLS) method. The
result of 2SLS shows that inflation rate above 1.5 percent hampers economic growth.
So they conclude by combining the result of OLS and 2SLS, the threshold level of
inflation in the US is 0 to 1.5 percent.

Mallik and CHowdhury (2001) examined the relationship between inflation and GDP
growth for four South Asian countries including Bangladesh, India, Pakistan and Sri
Lanka. The study used the annual data collected from IMF International Financial
Statistics (IFS). They used the cointegration and error correlation models and found
the major two results. First, there exist a long-run positive relationship between
inflation and economic growth for all four countries. Second, the sensitivity of growth
to changes inflation rate is smaller than that of inflation to changes in growth rates.
They suggested that moderate inflation is helpful for economic growth but faster
economic growth feeds into inflation.
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CHAPTER THREE: PRESENTATION AND ANALYSIS

3.1Weighted CPI of Nepal

CPI is the average of the price indices of the consumer goods and services in the
economy. The calculation of CPI in reality has to pass over the following steps:

Step 1: Determining the Basket of Goods and Services:

First step in the calculation of CPI is what goods and services are selected as
representative goods and services. Consumer consumes thousands of goods and
services in the economy but it is not feasible and relevant to track the prices of all
of them in practical. Thus, the first step is to determine “ Which goods and services
are to be included in the CPI?”. The representative item is called CPI basket. The
CPI basket is determined on the basis of consumer expenditure survey which
provides the relative importance of the goods and services in the consumer budget.

Generally, two criteria are applied: the expenditure share and frequency of
purchase. The CPI basket of Nepal consists of 496 goods and services. Those
goods and services have been selected on the basis of the expenditure weights
obtained from the fifth household budget survey
 19

Table: 3.1

The CPI basket of Nepal consists of 496 goods and services.

Case of Nepal

Group Name Goods Services Total

Food and Non-Alcoholic Beverages 162 162
Alcoholic Beverage, Tobacoo 14 14
Clothing and Footwear 67 8 75
Housing, Water, Electricity, Gas 5 5 10
Furnishing, Household Equipment 67 1 68
Health 21 11 32
Transport 7 10 17

Communication 3 5 8
Recreation and Culture 28 5 33
Education 0 28 28
Restaurants and Hotels 0 16 16
Miscellaneous Goods and Services 28 5 33
Grand Total 402 94 496

Table 3.1 shows that out of 496 good and services, 402 are goods and 94 are services.

Step 2: Selection of price collection centers:

After fixing the CPI basket, next step is selection of price collection centers. It is important
because prices cannot be collected from every outlet operating in the economy. While operating
selection of the price collection areas, the most important criteria are the size of economic
activity in those centers. The most used criteria is the expenditure share of the centers. This
implies that the remote parts of the country where the barter system prevails and the volume of
consumer purchase is negligible can be discarded. In reality, there are too many market centers
from people buy goods and services. In such a case, a representative number of the centers are
selected as the price collection centers.

In case of Nepal, altogether 60 price collection centers have been selected.

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Table 3.2:

Price Collection Centers in Case of Nepal

Market Type Selected

Rural 29
Urban 31
Grand Total 60

In Nepal there are 60 price collection centers, where 29 are from Rural areas and 31 from urban
area.

Step 3: Selecting the outlets and price collection methods:

The next task is to select the outlets (shops) from where to take the price levels. The outlets or
shops should be of normal category where average people buy goods and services. That
shouldn’t be large department store where elite people buy or shouldn’t be street type of market
where only poor people go. The next criteria are that the selected outlets (shops) should sell the
goods and services included in the CPI Basket. After fixing the outlets, price collection
mechanism is determined that is how much price of the single commodity is collected, frequency
of data collection and number of quotations to be taken for each goods and services.

Prices of some goods and services can be collected weekly and others may be done on a monthly
basis or even longer span of time. It depends on the speed of change and degree of volatility in
prices. To reduce biases, prices of the same good are collected from more than one outlet.

Prices of a good is collected from three different outlets in a price collection center on a weekly
monthly or quarterly basis

Table 3.3:

Price collection centers

Types No. of items

Monthly 141
Quarterly 287
Weekly 68
Grand Total 496

Out of 496 items included in a CPI basket, 141 items are collected in monthly basis, 287 items
are collected in quarterly basis and 68 items are collected in weekly basis.

Step 4: Selecting the method of averaging the price indices:

the most important part is the stage of averaging the price indices to get the CPI index. There
may be multiple stages of aggregation depending on the groups and sub groups of commodities
 21

as well as the geographical areas of the country for which different CPI indices are to be
produced. Indices at the upper level are calculated as the asymmetrical weighted averages of the
lower level indices by using either Laspeyre’s index formula or other indices/

The Laspeyre’s formula is given as:

L01= ∑𝒏𝒊=𝟎 𝑾𝒊𝑷𝒊

Where,

Wi = expenditure weights Pi = Price indices

Table 3.4

National Consumer Price Index (2014/15=100) Annual Average

Groups & Sub Groups Weight% 2016/17 2017/18 2018/19 2019/20

1 2 3 4
Overall Index 100 114.83 119.59 125.14 132.84
Food and Beverage 43.91 113.03 116.13 119.72 129.49
Cereal grains and their products 11.33 111.09 113.83 119.91 124.69
Pulses and Legumes 1.84 125.36 95.23 89.09 98.12
Vegetable 5.52 107.50 119.74 116.32 143.03
Meat and Fish 6.75 112.37 114.87 120.02 129.53
Milk products and Eggs 5.24 113.95 121.90 124.91 131.92
Ghee and Oil 2.95 112.34 115.06 122.36 127.51
Fruit 2.08 110.56 114.73 121.86 135.90
Sugar and Sugar products 1.74 123.16 122.33 118.24 124.13
Spices 1.21 119.93 114.02 120.37 137.22
Non-alcoholic drinks 1.24 108.50 111.71 115.96 120.91
Alcoholic drinks 0.68 126.14 135.78 150.56 165.60
Tobacco products 0.41 111.55 117.54 129.78 142.99
Restaurant and Hotel 2.92 117.08 122.77 128.73 134.83
Non-food and Services 56.09 116.27 122.38 129.551 135.52
Clothes and Footwear 7.19 124.68 132.08 141.00 148.69
Housing and Utilities 20.30 122.00 130.32 140.33 146.98
Furnishing and Household 4.30 112.94 117.16 123.85 129.47
equipment
Health 3.47 105.30 107.65 110.06 114.88
Transportation 5.34 100.92 102.86 109.30 111.00
Communication 2.82 104.86 105.38 103.81 105.64
Recreation and Culture 2.46 107.47 111.90 116.91 119.41
Education 7.41 120.90 130.62 137.15 144.36
Miscellaneous goods and 2.81 113.83 118.07 124.42 138.54
services
 22

Table 3.5

CPI Kathmandu Valley (3 Districts)

Groups & Sub groups Weight 2016/17 2017/18 2018/19 2019/2020

Overall Index 100 115.01 118.75 124.52 133.19
Food and Beverage 39.77 114.97 118.65 122.53 132.49
Non-food and Services 60.23 115.04 118.82 125.85 133.65

Table 3.6

CPI: Terai (19 Districts)

Groups & Sub groups Weight 2016/17 2017/18 2018/19 2019/2020

Overall Index 100 113.37 118.35 123.39 131.15
Food and Beverage 44.14 111.40 114.27 116.83 127.03
Non-food and Services 55.86 114.95 121.69 128.83 134.49

Table 3.7

CPI: Hill (25 Districts)

Groups & Sub groups Weight 2016/17 2017/18 2018/19 2019/2020

Overall Index 100 117.46 122.85 128.99 135.57
Food and Beverage 44.88 114.16 116.70 121.75 130.96
Non-food and Services 53.12 120.48 128.55 135.74 139.78

Table 3.8

CPI: Mountain (5 Districts)

Groups & Sub groups Weight 2016/17 2017/18 2018/19 2019/2020

Overall Index 100 113.20 119.83 125.71 131.88
Food and Beverage 59.53 111.42 116.96 120.68 127.42
Non-food and Services 40.47 115.87 124.17 133.51 138.73
 23

CHAPTER FOUR: CONCLUSIONS AND RECOMMENDATIONS

4.1 CONCLUSIONS

The study began with the premise that it is essential for the Nepal Rastra Bank to be aware of the
major determinants of inflation in Nepal, for meeting the objective of domestic price stability. In
this regard, it is felt that the study has achieved this main objective. This was achieved by the
study initially looking at a hybrid model of inflation - e.g. open economy monetary model with
structural factors - which had incorporated demand pull and cost push (via imported price)
theories of inflation. From this general model a specific model of inflation was developed for
Nepal which was subject to a battery of empirical exercises namely cointegration technique and
error correction modeling (ECM).

Empirical results suggest that inflation in Nepal is mainly determined by Indian inflation with
narrow money only having an effect in the short run (less than one year). The study attributed
this result to the geographical situation of having a shared open and contiguous border, which
facilitates informal trade and goods arbitrage, a rigid pegged exchange rate regime between both
currencies along with time varying capital mobility: i.e. it is less mobile in the short term (less
than one year) but being more so in the long term. The study had therefore concluded that within
the existing framework of pegged exchange rate and capital mobility, the main influencing factor
of inflation is from India with the NRB having control over domestic inflation only in the short
run (a one year window) but limited control beyond that.

The above results are similar with many other studies which suggest that inflation in India is an
important contributor for inflation in Nepal. For example, Thapa (2004) had stated, “…so long as
Nepal maintains fixed exchange rate regime with India, inflation cannot be the monetary policy
objective”. However, there has been discussion on the magnitude of influence. This study
suggests that there is a near unity relationship, which is corroborated with holding of absolute
and relative purchasing power parity. This result is also similar to IMF (1993), which has
concluded that Nepal’s inflation is basically determined by Indian inflation. In the words of IMF,
“When Nepal’s CPI is regressed on India’s WPI corrected for the exchange rate, the coefficient
on India’s price level is very close to 1”.
 24

4.2 RECOMMENDATIONS

Given this conclusion, the study makes three recommendations:

• First, to establish a mechanism to continuously monitor price developments in India

to ensure harmonization of domestic regulated prices (e.g. petroleum products etc.).
This is because with significant differences in the regulated prices between India and
Nepal, high level of arbitrages in border areas becomes common practices and thereby
affecting Nepalese inflation.

• Second, to commence studies for examining the implication of increasing the level
of capital mobility between both countries. Indian has already indicated for having
greater degree of capital convertibility in their 2006 report by the Tarapore
Commission. Such activities will likely have to be followed by Nepal. A greater
degree of capital convertibility will result in higher level of capital flow between both
countries. Given the existing rigid exchange rate, this make the window for the Nepal
Rastra Bank to influence inflation smaller. Further, there is an important implication
on the exchange rate policy currently followed by the country. While outside the
scope of the study, it is important to be proactive about the effects this will have.

• Third, to refine monetary policy formulation based on the above results. Presently,
monetary policy is geared toward maintenance of price stability. However, the
empirical exercise of the bank suggests that the main contributor for inflation in the
country is from India. This has implication and suggests that NRB should rethink - 37
- before commencing activities for having an inflation-targeting framework. Also and
given that the exchange rate policy is maintained, it is important to refine monetary
formulation in this regard
 25

REFERENCES

Aydin, C. (2017). The inflation- growth nexus: a dymanic panel threshold analysis for D-8
countries. Romanian Journal of Economic Forecasting , XX (4), 134-151.

Batini, N., & Yates, A. (2003). Hybrid inflation and price- level targeting. Journal of moeny,
credit and banking , 35 (3), 283-300.

Bernanke, B. S. (2006). The benefits of price stability. BIS Review , 13.

Bhattarai, B. (2014). Inflation and Growth: estimation of threshold level of inflation in Nepal.

Byanjankar, R. (2020). Determinants of inflation in Nepal: An application of ARDL bounds

testing approach to cointegration. NRB working paper-48 .

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