DYNAMICS OF INFLATION IN NEPAL

A Term Paper

Submitted to

Department of Economics

Tri-Chandra Multiple Campus

Faculty of Humanities and Social Sciences,

Tribhuvan University, Nepal

in the partial Fulfillment of the Requirements

for the degree of

MASTER OF ARTS

in

ECONOMICS

By:
Name: Sahitya Shrestha

Registration No. 7-3-28-64-2020

Class Roll No. 59

Subject: Micro-Economics – I
 ACKNOWLWDGEMENTS

This term paper has been prepared to meet the partial requirement of the fulfillment for
the internal evaluation of Micro-economics – I for first semester. I would like to extend
my immense gratitude to Mr. Bal Krishna Poudel, Faculty of this course for providing
such a learning opportunity regarding the dynamics of inflation in context of Nepal. I am
also thankful for his continuous support and constructive suggestions that has enabled
this term paper to achieve its present form.

Moreover, I would like to acknowledge the various authors of different studies that I
have referred during the preparation of this term paper.

I have tried my best to keep away this term paper from some possible errors. However,
there might be some errors in this paper for which I apologize to all. Further, I would like
to ensure that such mistakes won’t be committed in the future.

Sahitya Shrestha
MA Economics
1st Semester

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 TABLE OF CONTENTS

ACKNOWLWDGEMENTS ............................................................................................... i
TABLE OF CONTENTS ...................................................................................................ii
LIST OF FIGURES .......................................................... Error! Bookmark not defined.
ABBREVIATION ............................................................ Error! Bookmark not defined.
ABSTRACT ..................................................................... Error! Bookmark not defined.

CHAPTER I: INTRODUCTION .................................................................................... 1

1.1. General Background ................................................................................................ 1
1.2. Objectives of the Study ............................................................................................ 3
1.3. Rationale or Significance of the Study .................................................................... 3
1.4. Operational Definitions ............................................................................................ 4
1.4.1. Inflation ............................................................................................................. 4
1.4.2. Hyperinflation ................................................................................................... 4
1.4.3. Deflation ............................................................................................................ 5
1.4.4. Disinflation ........................................................................................................ 5
1.4.5. Food Price Inflation ........................................................................................... 5
1.4.6. Non Food Inflation ............................................................................................ 5
1.4.7. Purchasing Power .............................................................................................. 5
1.5. Limitations of the Study........................................................................................... 5
1.6. Organization of the Study ........................................................................................ 5

CHAPTER II: REVIEW OF LITERATURES ............................................................. 6

2.1. Theoretical Framework ............................................................................................ 7
2.1.1. Quantity Theory of Money ................................................................................ 7
2.1.2. Monetary Theory of Inflation ............................................................................ 7
2.1.3. Demand Pull Theory ......................................................................................... 8
2.1.4. Cost Push Inflation Theory................................................................................ 8
2.1.5. Structural Inflation Theory ................................................................................ 8
2.2. Review of Literatures ............................................................................................... 9
2.2.1. Review of International Literatures ................................................................... 9
2.3. Review of Nepalese Literatures ......................................................................... 11
2.3. Concluding Remarks .............................................. Error! Bookmark not defined.

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CHAPTER III: RESEARCH METHODOLOGY ...................................................... 13
3.1. Research Design ..................................................................................................... 13
3.2. Nature and Sources of Data ................................................................................... 13

CHAPTER IV: ANALYSIS AND PRESENTATION OF DATA .............................. 14

4.1. Trend of Inflation in Nepal .................................................................................... 14
4.3. Inflation related policies......................................... Error! Bookmark not defined.

CHAPTER V: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ...... 16

5.1. Summary ................................................................................................................ 16
5.2. Conclusion ............................................................................................................. 16
5.3. Recommendations .................................................................................................. 17

REFERENCES ............................................................................................................... 18

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 CHAPTER I: INTRODUCTION

1.1. General Background

Inflation is an important macroeconomic variable that is paid close attention by almost
all the countries around the world. Why inflation is major concern for all sounds to be an
interesting question. High and variable inflation distorts the smooth functioning of the
economy. To mitigate this, many countries have given their respective Central Banks the
objective of price stability. Nepal is no different in this regard, with the country having
conferred by Act (NRB Act, 2002) the responsibility of maintaining price stability on the
Nepal Rastra Bank (NRB), the Central Bank of Nepal. Before moving on to various
facets or dynamics of the inflation, it is very much essential to understand the basics of
inflation. The meaning of the inflation for general public and for the economists is same.
Both of them understands inflation as a rise in the general level of prices of goods and
services in an economy over a period of time as the consequence of which each unit of
currency buys fewer goods and services than before. Thus, it indicates the decline in
purchasing power of the money or of the general public.

Rising inflation has appeared as one of the core macroeconomic challenges in Nepal in
recent times. During the last five years, fiscal year 2007-08 experienced moderate single
digit inflation (6.7 percent) but it hovered around 13 percent in 2008-09 and remained in
the higher single digit in the rest of the period. Sudden rise in global fuel prices in 2008
led to a drastic increase in petroleum prices in the domestic market, which in turn
increased the cost of production of domestic products, resulting in rising prices of
consumer goods and services. The combined effect of the rise in food, commodity, and
fuel prices led to amplified prices starting from 2008. Since then, the inflation remained
on the higher side until the third quarter of 2011. However, inflation dropped to a four-
year low rate of 8.3 percent in 2011-12 due mainly to moderating food prices. But, based
on the seven months macroeconomics data, the current level of the consumer price
inflation is 10.1 percent.

In most of the cases, food inflation has been the main contributor to overall inflation.
Food prices witnessed a double-digit growth rates from April 2008 until September
2011. During these four years, the food price index rose from 118.5 to 194.3, recording
an increase of 64 percent. From October 2011 to April 2020, food inflation rate remained

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moderate at 6 percent on average due to the food surplus in the country and moderation
of food prices in India. However, food inflation started to rise after May 2020 mainly
because of the supply obstructions resulting from the political activities and reached 11.9
percent in July 2020 and has again dropped to 10.7 percent till mid February 2013.

In Nepal, inflation has posed the severe problem in overall welfare of the society. Since
the economy is in underdeveloped phase, the production in the economy is at very basic
level resulting in lower wages to the labor. Given the condition of the lower labor wages,
the purchasing power of the citizens is too feeble which has been further deteriorated by
the inflation. As poor and vulnerable households spend major share of their total
expenditures on basic foodstuffs, higher food prices erode their purchasing power. This
will increase the hardship of those who are already below the poverty line and also push
additional population below poverty line. Changes in food prices can affect poverty and
inequality through consumption and income channels. As food prices increase, the
monetary cost of achieving a fixed consumption basket increases leading to reduced
consumer welfare.

1.2. Statement of the Problem

The dynamics of inflation is still the doubtful in the academic and practical arena. Some
researches has shown the validity of the quantity theory of money while some others go
for the structural theory, cost push inflation theory and others. Thus, unanimity in
understanding the behavior of an inflation is very crucial for policy implications as well.
It is even more important for country like Nepal, where inflation is seen as major
challenges affecting the welfare and the development of the people and the country itself.
Thus, the studies regarding the dynamics of the inflation is urgently required that helps in
predicting the behavior of the inflation and policies can be framed accordingly. This
study has attempted to answer the following issues concerning the factors affecting the
inflation in Nepal.
a. What is the trend of inflation in Nepal?
b. What are the various factors that shapes the inflation in Nepal?
c. What is the relationship between the variables and the inflation?
d. Do the movement of inflation in Nepal are similar to those of developing and
developed countries?
e. What are the inflation related policies planned by the concerned authority?

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1.2. Objectives of the Study
As Nepal is experiencing the higher side of the inflation in recent past, it is very crucial
to understand the various factors that shape the inflation in Nepal. Thus, the general
objective of this paper is to analyze the various facets or factors influencing the inflation
in Nepal. However, the specific objectives of this paper are as follows:

To analyze the trend of inflation in Nepal.

a. To identify the various factors that shapes the inflation in Nepal.

b. To understand the relationship between the variables and the inflation.
c. To compare and contrast the movement of inflation in Nepal to those of some
neighboring countries.
d. To assess the inflation related policies planned by the concerned author.
e. To discuss the policy implication and provide some suggestions regarding the
dynamics of the inflation.

1.3. Rationale or Significance of the Study

Inflation has important bearing on social and economic development. As discussed
earlier, inflation can deteriorate the consumer’s purchasing power leading to less demand
of goods and services in the economy which may further lead to ceased production,
unemployment and decreased national income. It seems like the rotating wheel which
keeps on continuing with impact on different macroeconomic indicators that are of great
importance to any economy. It is important to have sound knowledge about how is
inflation shaped, how it works and what are its determinants so that proper policies can
be framed and surfaced to cope with the adverse consequences in the economy. Thus, the
first and the foremost significance of this study is that the factors influencing the
inflation can be identified along with the trend. In addition, this study unleashes the
diverse outcomes of inflation on different aspects of the economy. Moreover, the policy
implications of this study can be a way out to policy makers to strike the balance
between the inflation and other macroeconomic targets with more favorable guidelines
and strategy. Furthermore, this study helps in broadening the literature concerning the
dynamics of the inflation which might be of dire need to academician and future
researchers.

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1.4. Operational Definitions
Before starting the study in detail, it would be wiser to have glimpse on different terms
and terminologies that have been used frequently throughout this study. This is intended
towards providing the better understanding of the setting and the underlying concept
discussed further.

1.4.1. Inflation
Simple meaning of inflation purport the inflation as the increase in general price level of
goods and services measured over certain period of time while numbers of economists
have given their own thought about inflation which concludes the same meaning but with
different approaches. For instance, according to Pigou, “Inflation exists when money
income is expanding more than in proportion to increase in earning activity”. This
thought reveals that when people possess more cash or money, the demand in the
economy stimulates but due to less increase in productive activities, the supply does not
meet the demand hence causing for the increase in the general price level. Likewise for
Crowther, “Inflation is a state in which the value of money is falling, that is, prices are
rising”. It clarifies that during inflation the purchasing power of money declines due to
which goods and services becomes dearer which simply happens because of rising
prices. Similarly, G. Ackley has defined inflation as “Persistent and appreciable rise in
the general level or average of prices”. This view has forwarded some different aspect of
the inflation in a sense that to inflation to occur, it should be persistent. The short term
fluctuations in the prices are not regarded to be the inflation. In addition, the value of
inflation should be appreciable or somewhat realistic which could be accounted as valid
against the cases of inflation rate of 100 million percent and ten thousand percent which
occurred in some countries in past.

1.4.2. Hyperinflation
Hyperinflation is the most extreme inflation phenomenon which is characterized by three
or more digits increase in per year general price level. Hyper inflation is often said to be
the inflation with explosive acceleration i.e. growing faster. Extremely high inflation
could range anywhere between 50% and 100%. High inflation is a situation of price
increase of, say, 50%, 200% or more a year. Both kinds can be stable or dangerously
accelerate to enter in hyperinflation condition.

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1.4.3. Deflation
Deflation is a decrease in the general price level of goods and services. Deflation occurs
when the inflation rate falls below 0% or deflation is negative inflation rate). Inflation
reduces the real value of money over time; conversely, deflation increases the real value
of money. This allows one to buy more goods with the same amount of money over time.
Hence, the purchasing power of the consumer increases with deflation.

1.4.4. Disinflation
Disinflation is nothing but the slower rate of the inflation or when the inflation slumps
down to lower rate, it is called disinflation.

1.4.5. Food Price Inflation

The rise in general price level of the food and beverages item is what we call the food
inflation. Food inflation is very crucial issue since it is directly associated with day to
day livelihood of the consumers.

1.4.6. Non Food Inflation

Increase in price level of the non food items is known as the non-food price inflation.
Non food inflation affects the consumption of the durables and non-durable goods.

1.4.7. Purchasing Power

The value of a currency expressed in terms of the amount of goods or services that one
unit of money can buy is purchasing power. It is important because, all else being
equal, inflation decreases the amount of goods or services able to purchase.

1.5. Limitations of the Study

Limitation of this study arises from the scope of this study. This paper is not an extensive
work due to which important aspects of inflation may remain uncovered despite its
importance. In addition, simple analysis methodology has been used to present the
findings of the study which makes the study simple and limited in scope. Moreover, the
study has analyzed the inflation dynamics of short period of time which in fact may
provide the short run inflation dynamics leaving the long run inflation unaddressed.

1.6. Organization of the Study

The entire study has been divided into five chapters. Chapter one has thrown light on the
general introduction of the study which includes background of the study, objectives of
the study, significance, limitation and organization of the study. The review of both
international and Nepalese literatures along with the theoretical perspective has been

5
discussed in chapter two. Chapter three discusses with research methodology and it
includes research design, population and sample, nature, source and data analysis
methods. Chapter four is the main part study, which includes analysis and interpretation
of the data using financial and statistical tools. Finally, summary, conclusions and
recommendations have been made in chapter five.

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 CHAPTER II: REVIEW OF LITERATURES

2.1. Theoretical Framework

Inflation can be defined as the persistent rise in the general price level across the
economy over time. Mild inflation is considered to be desirable for economic growth.
However, high and variable inflation, in general, leads to uncertainties in income and
expenditure decisions of the different groups of the society; distorts economic growth;
lowers savings and investments; and makes more expensive cost of capital. High
inflation is more likely to raise unemployment than to lower it (Friedman, 1977). More
specifically, it hurts the poorest of the poor having fixed level of income, as inflation
erodes their real wealth or purchasing capacity. In other words, it further widens the
income inequality and distribution in society finally resulting in lost welfare of the
society and nation as a whole.
Having defined the inflation, it is very crucial to understand the theories regarding the
inflation. Since inflation is macroeconomic variable, there are number of macroeconomic
theories of inflation. Some of the underlying theories explaining the inflation and its
various facets have been discussed briefly in following sections.

2.1.1. Quantity Theory of Money

Simply stated, it asserts that changes in the general level of general prices are determined
primarily by changes in the quantity of money in circulation. David Hume provided the
first dynamic process analysis of how the impact of a monetary change spread from one
sector of the economy to another, altering relative price and quantity in the process. He
provided considerable refinement, elaboration and extension to the quantity theory of
money. David Ricardo purported that disequilibrium effects in short run and unimportant
in long-run equilibrium analysis. Irving Fisher spelled out his famous equation of
exchange viz. MV=PT.

2.1.2. Monetary Theory of Inflation

According to the monetarists, the money supply is the dominant, though not exclusive
determinant of both the level of output and prices in the short run, and of the level of
prices in the long run. The long- run level of output is not influenced by the money
supply. The monetarists emphasized the role of money. Modern quantity theory led by
Milton Friedman holds that “inflation is always and everywhere a monetary phenomenon

7
that arises from a more rapid expansion in the quantity of money than in total output. Its
earliest explanation was to be found in the simple quantity theory of money. The
monetarists employed the familiar identity of exchange equation of Fisher.

2.1.3. Demand Pull Theory

John Maynard Keynes and his followers emphasized the increase in aggregate demand as
the source of demand-pull inflation. The aggregate demand comprises consumption,
investment and government expenditure. When the aggregate demand exceeds the
aggregate supply at the full employment level, the inflationary gap arises. The larger the
gap between aggregate demand and aggregate supply, the more rapid is the inflation.
Keynesian theory do not deny this fact that even before reaching full employment
production factors and various appearing constraint can cause increase in public price.
According to demand-pull inflation theory of Keynes, policy that causes decrease in each
component of total demand is effective in reduction of pressure demand and inflation.

2.1.4. Cost Push Inflation Theory

Cost-push inflation is caused by wage increases enforced by unions and profit increases
by employers. The basic cause of Cost-Push inflation is the rise in money wages more
rapidly than the productivity of labor. The labor unions pressurize employers to grant
wage increases considerably, thereby raising the cost of production of commodities.
Employers in turn, raise prices of their products. Higher wages enable workers to buy as
much as before, in spite of higher prices. On the other hand, the increase in prices
induces unions to demand still higher wages. In this way, the wage-cost spiral continues,
thereby, leading to cost-push or wage-push inflation.

2.1.5. Structural Inflation Theory

This theory explains the effect of structural factors on inflation. In the economy,
structural factor causes supply increase related to demand-push even if abundant
unemployment production factor is impossible or slow. This inflation, giving the
structural improvement, results as a cost in fact that is given for immediate economic
growth. But, common anti inflation measures especially contraction monetary and
budget policy from their point of view, is nothing but only a prescription for stopping the
economic growth of non-developing countries, that also through experts that or rationing
developed investment countries and world organization under their supremacy and or by
understanding less developed economy features are disabled. From this viewpoint,

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inflation is manifestation change of economic and society is chosen from the fast
dynamic growth of economy.

2.2. Review of Literatures

Numerous empirical exercises which attempt to measure and understand the causes of
inflation have been conducted in both the developed and developing markets. Most of
the studies revealed that for developing countries with just started financial sectors, a
monetarist, demand-pull or structuralist theory of inflation may be more appropriate.
This chapter attempts to review some empirical studies on inflation focusing on large
groupings as well as those of individual country studies (both international and also
national level studies).

2.2.1. Review of International Literatures

Vogel (1974) developed a monetary model for explaining inflation in Latin America.
The study concluded that the coefficients of current money supply and one year lagged
money supply are highly significant and thus indicate that an increase in the rate of
growth of money supply causes a proportionate increase in the rate of inflation within
two years. At the same time the rate of inflation is found to be inversely influenced by
the growth rate of real income.

Campillo and Miron (1996) examined 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. It was found that 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.

The study conducted by Domac and Elbirt (1998) concluded that inflation exhibits strong
seasonal patterns associated with agriculture seasonality with monetary aggregates
matching inflation by lag of two-months and that the exchange rate also exhibits a stable
seasonality pattern. In addition, M1 i.e. currency in circulation plus demand deposits and
the exchange rate have predictive impact for most components of the CPI. Moreover, it
was found that an increase in the fiscal deficit would undermine competitiveness by
producing appreciation in the real exchange rate while the cointegration and error-

9
correction model showed that inflation is positively related to both money supply and the
exchange rate and negatively related to real income in the long run.

Dlamini et al. (2001) attempted to identify the relevant influencing factors of inflation in
Swaziland using both open monetary and structural variables over the period 1974 -
2000. The study found that money supply and interest rate has insignificant influence on
inflation. The coefficient of real income growth was also insignificant, though it was
positive. However, foreign price (i.e. South African inflation) and exchange rate has a
significant long-run influence in inflation. It was also found that a large interdependence
between wages and inflation exist both in the short-and long run. The authors concluded
that changes in the lagged exchange rate, South African inflation and nominal wages
were major determinants of inflation in Swaziland.

Likewise, Lissovolik (2003) examined the transitional economy of Ukraine from a

monetary and structural perspective using monthly data over the period 1993 - 2002 and
concluded that money, wage and exchange rate largely affect inflation.

In the long run, monetary factors play a dominant role in inflation with a lag effect of
one year, whereas administered prices influence inflation in the short-run only in
Pakistan (Khan and Shimmelpfinnig, 2006). The study examined the relative importance
of monetary and supply side factors for inflation in Pakistan over the period 1998 to
2005.The model used in this study included money supply, credit to private sector and 6-
month Treasury bill rate as monetary variables and nominal effective exchange rate,
wheat prices guaranteed by the government as supply side factors. Both annual real and
nominal GDP were interpolated to 12- month moving average as activity variable.

When analyzing determinants of inflation in Chad and Mali, Diouf (2007) found that
average rainfall explains inflation significantly. Finally, accommodative policies,
especially those followed by massive injection of money in the economy, generally put
upward pressure on prices hence stimulating the inflation in the economy.

Kabundi (2020) conducted the study to identify the main factors underlying inflation in
Uganda, both in the long - and short-rung, using monthly data from January 2005 to
October 2011. Over the long-run, monetary aggregate, world food prices, and domestic
supply and demand effects in agricultural sector are main determinants of inflation in

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Uganda. While money growth, world food prices, and energy prices, combined with
domestic food prices have short-term impact on inflation.

2.3. Review of Nepalese Literatures

The earliest studies in Nepal are by Fry (1974), Pant (1977) and Pant (1978). These
studies showed a weak association between money and prices using basic statistical
analysis. These studies generally looked at the inflationary process in Nepal from a
closed economy monetary perspective. In fact, Pant (1977) showed that inflation in
Nepal is not much explained by the movement of monetary aggregates, rather it is
mainly due to structural changes in the economy. These conclusions contrast with the
observation of Sharma (1987) who identified the influencing factor of India and was also
shown empirically by Khatiwada (1981). The author had adjusted the above mentioned
closed economy model to take into account external influence and found a relatively
strong relationship of both narrow money and Indian prices, with Nepalese prices.

Neupane (1992) had continued exploration of the appropriate model for Nepal and
examined both monetarist (closed economy) and structuralist approaches to the inflation
process in Nepal over the period 1965 to 1988 by using OLS technique. The findings of
the study suggested that monetary policy is an important instrument to control inflation.
An increase in money supply in line with the growth of per capita GDP could help to
control inflation.

Institute for Sustainable Development (ISD; 1994), in a study conducted for NRB,
identified money supply, international prices (particularly Indian prices), exchange rate,
real output, government expenditure and expectation factors as major sources of inflation
in Nepal. Similarly, infrastructural bottlenecks, imperfect market condition and market
oriented economic policies are also instrumental for inflation escalation. The study
utilized simple regression analysis and find that the explanatory power of a closed
economy monetarist model (where price is the function of money supply and real output)
is very low; the study therefore included external variables of an open economy model of
regression analysis which includes Indian wholesale price exchange rate, lagged effect of
money supply, government expenditure as additional explanatory variable. ISD (1994)
found that a 10 percent increase in Indian prices causes a more than 8 percent rise in
domestic price level in Nepal.

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Khatiwada (1994) examined the inflation process in Nepal utilizing basis the quantity
theory of money. Initially, results showed low explanatory power and suggested that
there were other missing variables in the equation. When open economy variables, such
as Indian inflation and the exchange rate, were included this showed significant increase
in the explanatory power of the equation. The study found that Import price Index (IPI)
is consistently significant and suggested that inflation in Nepal is influenced by open
economy forces.

Mathema (1998) has used an expectation augmented Phillips Curve approach to examine
whether the nominal wage increases are the most significant sources of cost push
inflation. The author found the importance of several wage variables for influencing
domestic inflation but surprisingly did not find significant effect of imported prices.

Pandey (2005) identified money supply (both narrow and broad), real GDP, government
expenditure, Indian inflation and exchange rate as explanatory variables influencing
inflation, over the period 1973 to 2004. However, the error-correction term was found
not to be significant, suggesting that there is no short run adjustment with regard to
inflation in Nepal.

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 CHAPTER III: RESEARCH METHODOLOGY

Research methodology clarifies the overall plan and a basic framework on which the
study is based. Before presenting the analysis and interpretation of data, it is necessary
that research methodology be described first. This chapter deals with the research design,
nature and sources of data, and methods of analysis of information.

3.1. Research Design

This study has employed case study research design in order to find out and identify the
various factors that affects the inflation in Nepal. In doing so, the study has used
numerous research articles on dynamics of inflation both from national and international
level. In addition, a correlational and causal comparative research design has also been
used to investigate the relationship between the inflation and its determinants.
Furthermore, to analyze the past trends and movements of inflation descriptive
methodology has also been added as the tool for this study.

3.2. Nature and Sources of Data

This study has used the secondary data of various macroeconomic variables of Nepal.
The economic survey report published by the government of Nepal (GoN) is the primary
source of the data for the study. Apart from this, the report on macroeconomic situation
published by NRB has also been referred to collect the data. Data on consumer price
inflation, salary and wages, narrow money supply, broad money supply, domestic credit,
imports and oil prices etc. from the year 2002 to 2020 has been use to understand the
dynamics of the inflation in Nepal.

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 CHAPTER IV: ANALYSIS AND PRESENTATION OF DATA

This section of the study provides systematic presentation and analysis of data to deal
with various issues associated with inflation in the context of Nepal. Various statistical
and econometric models described in chapter three have been used for this purpose.

4.1. Trend of Inflation in Nepal

Figure 4.1 illustrates the historical inflation series of Nepal as measured by consumer
price index from 2002 to 2020. Looking at the inflation series, inflation in Nepal has
fluctuating trend over the past 3 decades. Observing the graph, the highest inflation
occurred in the year 1992 when the inflation rate was as high as 22 percent while over
last 3 decades, the lowest rate of inflation was 2.45 percent in the year 2001.

For last five years, the inflation rate stood around 10 percent annually except for the year
2009 when inflation rate was 13 percent. According to NRB (2021), over the period from
2002 to 2020, average rate of inflation remained at 8.23 percent. This growth rate is
decomposed into growth rate of Food and Beverage group (FBG) and that of Non-food
and Services (NFS) group which was 8.17 percent and 8.39 percent respectively.
Similarly, the prices of FBG have been observed more volatile over the period compared
to NFS.

During 2000s, inflationary pressure continued its double-digit level, mainly due to
structural changes in the economy. Average inflation over the period 2008 to mid-2009
was 11.26 percent. Although there was relatively improved supply situation, the impact
of the gulf war, low agricultural production and relatively higher inflation in India etc.

14
led to an upward pressure on inflation during the period. Nepal witnessed the highest
ever-recorded level of inflation, 14 percent, in 2004. During that period, average growth
rate of the prices of FBG was soared at 24.49 percent and NFS also increased to 14.89
percent. The higher rise in the index of FBG was mainly due to the sharp rise in the
index of rice and rice products and spices. The devaluation of Nepalese rupees vis-à-vis
US dollar and other convertible currencies by 20.9 percent on July 1, 2002 was also
responsible for exceptional rise in the rate of inflation during that fiscal year. In addition
to this, higher rate of inflation in India also caused rise in the prices of the imported
goods from India.

Based on seven months data of FY 2020/21, current rate of inflation is below 5 percent.
The index of food and beverage group increased by 5.5 percent whereas non-food and
services group increased by 4.5 percent in mid February 2020.

4.2 Inflation Related Policies

It is under the purview of the NRB to look after monetary matters of the country;
however, it is not the sole authority. Government often comes into action through the
suggestions and the macro economic targets as framed in the fiscal policy of the country.
Thus, NRB on behalf of the government controls the monetary measures and the
inflation. It is primary objective of the NRB to maintain the price stability in the country.
For that, it controls the flow of money in the market through the banking channels. As
per the need, it injects the money and mop up the money from the economy using its
monetary tools like cash reserve ratio (CRR), open market operation (OMO) and bank
discount rate (DR). Using these tools, the central bank signals the financial institutions to
adjust the market interest rates which alter the flow of credit, money in circulation and
the deposits. Currently, in first seven months of fiscal year 2020/21, NRB has decreased
the narrow supply by 0.5 percent to cope with prevailing high inflation rate. The NRB
mopped up net liquidity equivalent to Rs. 8.50 billion under the open market operation
through outright sale auction in first seven months of 2020/21.

15
 CHAPTER V: SUMMARY, CONCLUSIONS AND
RECOMMENDATIONS

5.1. Summary
The studies associated with dynamics of inflation provide an important insight into the
understanding of factors influencing the inflation and its implication to overall economy.
Much attention has been paid in past in this regard to explore what determines inflation
rate in the context of developed and developing economies. In recent years, studies have
started to examine this phenomenon in the context of underdeveloped economies around
the globe as well. However, little efforts have been made to explore this issue in the
context of Nepal. Therefore, this study attempted to identify how different
macroeconomic variables are associated with movement in inflation in Nepal.

As already mentioned, this study intended to identify the factors influencing inflation
rate in Nepal. Using case study and causal comparative research design, the study also
attempted to analyze the relationship between the variables and to assess the historical
trend of inflation in Nepal.

5.2. Conclusion
The major conclusion of this study is that the most influencing factor affecting the
inflation rate in Nepal is Indian inflation rate. The close relation between Nepalese and
Indian inflation is consistent with many studies. For example Pandey (2005) found that
one percent change in M1 and Indian inflation (measured by wholesale price index)
caused 0.43 percent and 0.59 percent changes in inflation in Nepal respectively. He also
found one period lag adjustment by 0.45 percent. Similarly, ISD (1994) has also
observed that each 10 percent increase in Indian prices causes more than 8 percent rise in
Nepalese prices. On the other hand, wage and salary does not seem to increase the
inflation rate rather it is found to reduce the inflation which is inconsistent with the cost
push theory of inflation. This result is inconsistent with the studies of Mathema (1998),
Lissovolik (2003) and Dlamini et al., (2001). The results indicate very strong role of
domestic credit in explaining the inflation. The study found that domestic credit and the
inflation rate are inversely related with each other which again depict the inconsistency
with the monetary theory of the inflation. When, the domestic credit increases, it should
cause the rise in price level; however, the study found reverse relation with the domestic

16
credit. In contrast, the money supply both broad and narrow has positive impact on
inflation indicating that every 1 percent rise in money supply will increase the inflation
approximately by 0.14 percent in the long run. However, the money supply in the short
run does not seem to affect the inflation rate as indicated by the insignificant regression
coefficient. This finding is in line with Vogel (1974), Domac and Elbirt (1998), Dalmini
et al., (2001) and Pandey (2005). Finally, the annual growth in imports and oil price are
positively related with the rate of inflation with both coefficients being significant at 5
percent level. However, the predictive strength of import growth is superior in
comparison to the increase in oil prices. This result is consistent with Khatiwada (1994).

5.3. Recommendations
Since inflation in Nepal is significantly influenced by Indian inflation, having an
inflation target within the present domestic context requires making more vigorous
exercise especially in the context of present arrangement that suggests Nepal has been
importing the favorable inflation performance of India. This can also be seen in the
monetary policy statements for continuation of the pegged exchange rate regime with
Indian currency. This and many other studies on dynamics of inflation in Nepal has
shown the effect of Indian prices or inflation to be much stronger than the monetary
aggregates, the concerned authority should work out on various available alternatives
other than monetary tools to cope with the inflation.

Since the monetary aggregates seems to have effect in the long run, the concerned
authority should realize the delayed effect of the money supply in the economy and
frame the policies accordingly thereby increasing the efficiency of monetary tool in
controlling the inflation.

Supply side deficiency is also an important factor of price hiking. So the supply side
must also be strengthened to contain inflation within the target. Rising inflation in Nepal
has been mainly driven by food price inflation. So we must seek out to solve the issue of
price hiking in food products by providing subsidies and following the policy of
protectionism in food products. Finally, the inflation could be maintained at acceptable
level if imports and reduced and the economy becomes more productive. It also reduces
the effect of Indian inflation in rate of inflation in Nepal.

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