Dynamic of Inflation Report-1

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CHAPTER I

INTRODUCTION

Generally inflation means that your money wont buy as much today as you

could yesterday. Inflation is when the prices of most goods and services continue to creep

upward. Inflation can be defined as the persistent rise in the general price level across the

economy over time.

In other words, Inflation can be defined as a sustained increase in the general level of

prices for goods and services. It is measured as an annual percentage increase. As inflation

rises, every dollar you own buys a smaller percentage of a good or service. Inflation can

affect different parts of the economy at different times. For example, oil prices move up and

down rapidly, because they are driven by the bids on the price of oil futures contracts. As a result,

gas prices are also very volatile and this can drive up the price of food and so on.

Inflation is normally associated with high, prices, which causes decline in the purchasing

power or the value of money, inflation refers to the substantial and rapid increase in the

general price-level, inflation is primarily a monetary phenomenon. Prices keep on rising

due to excess supply of money and lower production of exchangeable goods.

The rate at which the general price level for goods and services is rising, then the

purchasing power is falling. Central banks attempt to stop severe inflation, along with

severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

1.2. How Inflation are Measured?

Measuring inflation is a difficult problem for government statisticians. To do this, a

number of goods that are representative of the economy are put together into what is

referred to as "market basket."

In North America, there are two main price indexes that measure inflation:

Consumer Price Index (CPI) - A measure of price changes in consumer goods and

services such as gasoline, food, clothing and automobiles. The CPI measures price

change from the perspective of the purchaser.

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Producer Price Indexes (PPI) - A family of indexes that measure the average

change over time in selling prices by domestic producers of goods and services.

PPIs measure price change from the perspective of the seller.

1.3. Causes of Inflation

1.3.1. Demand-Pull Inflation - This theory can be summarized as "too much money

chasing too few goods". In other words, if demand is growing faster than supply, prices

will increase. This usually occurs in growing economies. This shortage of supply enables

sellers to raise prices until equilibrium is put in place between supply and demand.

1.3.2. Cost-Push Inflation It is also known as "supply shock inflation", suggests that

shortages or shocks to the available supply of a certain good or product will cause a ripple

effect through the economy by raising prices through the supply chain from the producer to

the consumer.

1.3.3. Wage Push Inflation Rising wages tend to cause inflation. In effect this is a

combination of demand pull and cost push inflation. Rising wages increase cost for firms

and so these are passed onto consumers in the form of higher prices.

1.3.4. Imported Inflation Depreciation in the exchange rate will make imports more

expensive. Therefore, the prices will increase solely due to this exchange rate effect. A

depreciation will also make exports more competitive so will increase demand.

1.3.5. Temporary Factors The inflation rate can also increase due to temporary factors

such as increasing indirect taxes.

1.3.6. Money Supply is also the one factors causing inflation

1.3.7. Inflation can artificially be created through a circular increase in wage earnersdemands and then the subsequent increase in producer costs which will drive up the prices

of their goods and services. This will then translate back into higher prices for the wage

earners or consumers. As demands go higher from each side, inflation will continue to rise.

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CHAPTER II

METHODOLOGY

Literature Review

There are large numbers of empirical exercises, which attempt to measure and understand

the causes of inflation. For developing countries with embryonic 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). The chapter ends with some thoughts of the appropriate empirical methodology

for the study.

The study concluded that inflation and monetary aggregates are positively correlated in the

long run. However, as the time horizon shortens, the correlation falls. 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).

Razzak (2001) examined the New Zealand experience from a monetary perspective and

showed that the time series correlation between inflation and monetary aggregates was high

only during high-inflation periods and disappeared when inflation was low.

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.

Maliszewski (2003) examined inflation-determinants in Georgia and the relationship

between prices, money and exchange rate over the period 1996:1 to 2003:2.

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CHAPTER III

INFLATION IN NEPAL

3.1. History of Inflation

An increase in the general level of prices implies a decrease in the purchasing power of the

currency. That is, when the general level of prices rises, each monetary unit buys fewer

goods and services. Increases in the quantity of money or in the overall money supply (or

debasement of the means of exchange) have occurred in many different societies

throughout history, changing with different forms of money used. For instance, when gold

was used as currency, the government could collect gold coins, melt them down, mix them

with other metals such as silver, copper or lead, and reissue them at the same nominalvalue. This practice would increase the money supply but at the same time the relative

value of each coin would be lowered. As the relative value of the coins becomes lower,

consumers would need to give more coins in exchange for the same goods and services as

before. These goods and services would experience a price increase as the value of each

coin is reduced.

Historically, infusions of gold or silver into an economy also led to inflation. From the

second half of the 15th century to the first half of the 17th, Western Europe experienced a

major inflationary cycle referred to as the "price revolution", with prices on average rising

perhaps six fold over 150 years. This was largely caused by the sudden influx ofgold and

silverfrom theNew World into Habsburg Spain. The silver spread throughout a previously

cash-starved Europe and caused widespread inflation. Demographic factors also

contributed to upward pressure on prices, with European population growth after

depopulation caused by the Black Death pandemic. By the nineteenth century, economists

categorized three separate factors that cause a rise or fall in the price of goods: a change in

the value or production costs of the good, a change in the price of money which then was

usually a fluctuation in the commodity price of the metallic content in the currency, and

currency depreciation resulting from an increased supply of currency relative to the

quantity of redeemable metal backing the currency. Following the proliferation of private

banknote currency printed during the American Civil War, the term "inflation" started to

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appear as a direct reference to the currency depreciation that occurred as the quantity of

redeemable banknotes outstripped the quantity of metal available for their redemption. At

that time, the term inflation referred to the devaluation of the currency, and not to a rise in

the price of goods. The adoption offiat currency (paper money) by many countries, from

the 18th century onwards, made much larger variations in the supply of money possible.

Since then, huge increases in the supply ofpaper money have taken place in a number of

countries, producing hyperinflations -- episodes of extreme inflation rates much higher than

those observed in earlier periods.

Figure 1 History of Inflation

3.2. Historical Perspective of inflation in Nepal

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Measurement of prices in Nepal began from 1973 using the expenditure weightage of the

goods and services of the people obtained from first HBS. Prior to that, equal weights

were- 7 -assigned for each and every commodity of the basket. The inflation from 1976 -

2006, as shown graphically below:

Figure 2 Trend of Inflation in Nepal

3.3. Costs of Inflation in Nepal

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different

people in different ways. It also depends on whether inflation is anticipated orunanticipated. If the inflation rate corresponds to what the majority of people are expecting

(anticipated inflation), then we can compensate and the cost isn't high. For example, banks

can vary theirinterest rates and workers can negotiate contracts that include automatic

wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

Creditors lose and debtors gain if the lender does not anticipate inflation correctly.

For those who borrow, this is similar to getting an interest-free loan.

Uncertainty about what will happen next makes corporations and consumers less

likely to spend. This hurts economic output in the long run.

People living off a fixed-income, such as retirees, see a decline in their purchasing

power and, consequently, their standard of living.

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The entire economy must absorb re-pricing costs ("menu costs") as price lists,

labels, menus and more have to be updated.

If the inflation rate is greater than that of other countries, domestic products become

less competitive.

3.4. Nepal-Inflation Average:

The Average Inflation in Nepal was reported at 13.23 percent change in 2009, according to

the International Monetary Fund (IMF). In 2015, Nepal's Average Inflation is expected to

be 5.00 percent change. Data for inflation are averages for the year; not end-of-period data.

In 2009, Nepal's economy share of world total GDP, adjusted by Purchasing Power Parity,

was 0.05 percent. In 2015, Nepal's share of world total GDP is forecasted to be 0.05

percent. This page includes a chart, historical data and forecast for Nepal's Average

Inflation. the most common gauge of inflation is known as the CPI, or consumer price

index, which measure the price increases (decreases) of basic consumer goods and

services. The GDP deflatoris another very important measure of inflation as it measures

the price changes in goods that are produced domestically. In effect, inflation decreases the

value of your money and makes it more expensive to buy goods and services.

Figure 3 Nepal-Inflation Average

3.5. Inflation in Nepal

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According to the latest macroeconomic report from Nepal Rastra Bank (NRB), the year-on-

year (y-o-y) Consumer Price Inflation (CPI) moderated to 9.9% in mid November

2009.Though still high compared to international standards, after reaching the highs of

above 14%on mid Jan 2009, inflation has moderated gradually during the last few months

(see figure 1).The annual budget of the Ministry of Finance (MOF) of Nepal for 2009/10

and the monetary policy of the NRB has projected an inflation target of 7% for Fiscal Year

(FY) 2009/10. The annual average inflation in FY 2008/09 was 13.2% which was higher

than the target of 7%. Units annual monetary policy report, the NRB has indentified supply

side constraints as the primary cause of the high inflation. Inflationary pressure, according

to the NRB macroeconomic report, has been driven primarily by significant price rise of

16.4% in food and beverages group and a moderate rise of 2.2% in other products.

Figure 4 The Year-on Year (y-o-y) inflation figure (Source: NRB)

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CHAPTER IV

INFLATION MEASURE FOR NEPAL

For the conduct of monetary policy, the most commonly used price indicator in Nepal is

the consumer price index (CPI) inflation. But, it is widely recognized that, at times, the CPI

inflation can be a misleading indicator of the underlying inflation. Thus, many central

banks have found it useful to monitor core inflation measures, which separate temporary

shocks from the inflationary process and, hence, represent the underlying price movements

more accurately.

Core inflation is useful in the conduct of monetary policy in two ways. First, since coreinflation excludes temporary price fluctuations originated from supply disturbances, it

could considered as a measure of inflation that is the outcome of policy and, hence, more

controllable by the monetary authorities. Second, because monetary policy affects

economic activity with long and variable lags, it is not a good tool for countering

temporary price movements, so policymakers are more interested in the inflation outlook.

To the extent that measures core inflation measures can isolate the underlying trend to

which inflation will return, they could be a useful short-term guide for future projections of

total CPI inflation.

Two core inflation measures for Nepal are developed here to allow us to analyze the

underlying price movements. The analysis of core inflation measures will make it possible

to determine: (i) whether or not, and to what extent, temporary shocks to inflation in India

translate to domestic inflation in Nepal; and (ii) whether the temporary shocks in Nepal are

important sources.

Core Inflation Measures for Nepal

Despite its prevalence, there is no agreed method of measuring core inflation. Literature

provides two broad approaches: statistical and model-based. The most popular statistical

approaches are exclusion-based measures and trimmed-based measures pioneered by Bryan

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and Cecchetti (1993). The model-based approach pioneered by Quah and Vahey (1995)

attempts to develop core inflation measures by using a multivariate econometric model.

This approach suffers from a number of drawbacks, including sensitivity to the

assumptions underlying the model and sample changes, which limit the usefulness of these

inflation measures.

Effects of Inflation on Nepal

The most immediate effects of inflation are the decreased purchasing power of the dollar

and its depreciation. Depreciation is especially hard on retired people with fixed incomes

because their money buys a little less each month. Those not on fixed incomes are more

able to cope because they can simply increase their fees. A second de-stabilizing effect is

that inflation can cause consumers and investors to change their speeding habits. When

inflation occurs, people tend to spend less meaning that factories have to lay off workers

because of a decline in orders. A third destabilizing effect of inflation is that some people

choose to speculate heavily in an attempt to take advantage of the higher price level.

Because some of the purchases are high-risk investments, spending is diverted from the

normal channels and some structural unemployment may take place. Finally, inflationalters the distribution of income. Lenders are generally hurt more than borrowers during

long inflationary periods which mean that loans made earlier are repaid later in inflated

dollars.

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CHAPTER V

INFLATION AND THE WORLD ECONOMY

The turbulent US economy has experienced its share of rough conditions and the threat of

inflation during the past five years. While an economic recovery is expected to occur over

the next five years, any increase in inflation would inhibit growth and raise prices for

almost every industry. The threat of inflation is on the minds of businesses and consumers

alike, with the depreciation of the US dollar signifying a fall in buying power for

Americans, especially in contrast with emerging global economies. Since the economy is

growing at such a slow pace, inflation is not expected to severely affect operators yet.

However, as the economy improves, inflationary pressure will rise. In light of these trends,

IBIS World projects that inflation will adversely affect some industries, but others will

emerge victorious.

IBIS World analysis indicates that a number of industries will experience changes as

emerging economies take a step forward, stoking inflationary pressures. Emerging

economies like China and India are experiencing particularly strong growth, and this trend

will continue into the five years to 2016. Furthermore, faster growth will put pressure on

US purchasing power by contributing to a depreciating dollar. The changing economic

landscape will affect industries in different ways, causing some to obtain growth and

others to suffer losses. The most successful businesses will be able to adapt to the new

environment.

Oil

During the recession, the Oil Drilling and Gas Extraction industry experienced major

fluctuations, and its role in the US economy will continue to be significant. Since theUnited States imports a substantial amount of oil, the global economy and worldwide

supply and demand will prove to be major factors; therefore, it is influenced by inflation.

Oil production will pick up globally, but it is declining domestically; the country remains

dependent on foreign imports for gasoline. Despite escalating fears, the price of gasoline is

not expected to skyrocket, at least for the time being. Furthermore, currently increasing

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prices are supporting industry growth, since demand for gas is on the rise. From 2010 to

2011, IBISWorld expects that industry revenue will increase by 7.9% to $329.9 billion,

reflecting strong domestic demand. IBISWorld industry analyst Justin Molavi estimates

that prices are rising at short-term rates, but they will not reach $4 at the pump anytime

soon because the economy is recovering so slowly. However, consumers fears are valid,

since gasoline will likely continue increasing in price as demand from emerging economies

grows. While increasing prices have helped domestic operators secure revenue, further

escalations may cause them to seek out alternatives to gasoline.

Tourism

An unexpected market to benefit from inflation, the Tourism industry will face mostly

positive conditions coming out of the recession. Because emerging economies are

performing strongly, demand from international travel will grow. IBISWorld industry

analyst Nima Samadi says that inbound travel to the United States will likely rise because

the country will be cheaper for tourists to visit. This trend will stimulate revenue for the

Tourism industry and other businesses. Therefore, from 2010 to 2011, industry revenue is

expected to increase at a rate of 4.1% to total $1.4 billion. The depreciating dollar hurts

outgoing travel since US consumers will be less likely to travel overseas; however, demand

will remain strong because of other factors. Samadi explains that the depreciation of the

dollar will encourage consumers to travel within the United States, fueling revenue for a

number of operators and industries. Since Americans would lose buying power, it

encourages people to stay in the United States and hurts outgoing foreign travel.

Agriculture and food

While many US manufacturers will experience declines in light of global economic

strength and cheaper labor overseas, agriculture in the United States will be a promising

market. The United States can achieve greater efficiency than developing countries because

it relies on technology rather than labor. Since it is not a labor-intensive activity, it will

likely experience growth; unlike developing countries, the United States has the capital to

employ automation technologies that decrease the need for labor. According to IBISWorld

industry analyst Nikoleta Panteva, domestic production of soybeans and oilseeds will

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particularly benefit the industry since these products go to renewable energy. For example,

from 2006 to 2011, the Oilseed Farming industrys revenue is expected to increase at an

average annual rate of 9.4% from $552.9 million to $866.8 million, reflecting strong

growth in demand. While grains and oilseeds are growing segments for the industry,

domestic markets depend on global producers for many fruits and vegetables. Since many

fruits and vegetables are grown outside the United States, inflation adversely affects

downstream markets because they will not be able to purchase goods as cheaply. On the

other hand, US farmers will likely benefit from this trend since demand for domestically

grown fruits and vegetables will rise.

Surviving and thriving

Inflation and the growth of emerging economies will threaten domestic industries in the

next five years. Many industries will experience a combination of negative and positive

effects as they aim to overcome the consequences. While the Oil Drilling and Gas

Extraction industry experienced major fluctuations during the recession, revenue will begin

to pick up in 2011. Furthermore, gas prices are not expected to skyrocket, despite fears

from consumers. Metal industries have faced sharp rises and falls, but the threat of inflation

will stimulate demand for gold and the recovering construction markets will support

aluminum growth. Despite decreasing demand for overseas travel, the depreciating dollar

will make it less expensive for visitors to travel to the United States, strengthening the

Tourism industry. The agriculture and food industries will also experience negative and

positive effects, with overseas markets for fruit and vegetables hurting domestic demand

but grains and oilseeds thriving. Last, the transportation industries will benefit from a rise

in demand for cars and higher mileage due to more people commuting. In the end,

businesses will need to adapt to these changes in order to thrive in the midst of inflation

and shifts in the global economy.

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CHAPTER VI

POLICIES TO CONTROL INFLATION

This report focuses on policies that can be used to control the rate of inflation. Our startingpoint is that inflation comes from more than one source. Rising prices are not simply the

result of increasing aggregate demand but also from higher costs of production and the

direct and indirect effects of changes in government policies. It is also important to note

that many inflationary impulses come from outside the domestic economy - namely from

external shocks in the global economic system - many of which an individual country has

no control to change.

Thinking about the domestic economy, inflation can be reduced by policies that

(i) slow down the growth of AD or

(ii) boost the rate of growth of aggregate supply (AS)

The main anti-inflation controls available to a government are:

Fiscal policy: If the government believes that AD is too high, it may choose to tighten

fiscal policy by reducing its own spending on public and merit goods or welfare payments.

Or it can choose to raise direct taxes, leading to a reduction in real disposable income. The

consequence may be that demand and output are lower which has an effect on jobs and real

economic growth in the short-term. A fiscal tightening will have the effect of reducing the

size of the budget deficit.

Monetary policy: A tightening of monetary policy involves the central bank introducing

a period of higher policy interest rates to reduce consumer and investment spending.

Monetary policy is designed mainly to control demand-pull inflationary pressures. But it

also has an effect on costs, not least through the effect of changes in interest rates on the

value of the currency. Make sure that you understand the ways in which interest rates feed

through to affect the components of aggregate demand, output and inflationary pressures.

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Supply side economic policies: Supply side policies include those that seek to increase

productivity, competition and innovation all of which can maintain lower prices. These

are important ways of controlling inflation in the medium term. If the economy can raise its

underlying growth rate, then a higher level of aggregate demand can be sustained without

leading to acceleration in the rate of inflation.

Figure 5 LRAS and Inflation

The most appropriate way to control inflation in the short term is for the government and

the central bank to operate fiscal and monetary policy to keep control of aggregate demand

to a level consistent with our productive capacity.

The standard consensus among economists (until recently) has been that AD is probably

better controlled through the use of monetary policy rather than an over-reliance on using

fiscal policy as an instrument of demand-management. But in the long run, it is the growth

of a countrys supply-side productive potential that gives an economy the flexibility to

grow without suffering from acceleration in cost and price inflation.

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Table 1 Policies to control inflation

Identify Explain Evaluation

Contractionary

Monetary Policy

Lower MS rise in interest rate

cost of borrowing increases

reduces I + C purchased with loans

fall in AD GPL falls

Inappropriate for cost-push inflation

Time lag, but shorter than FP: sellbonds to public

Unpredictable effect on C and I

Contractionary

Fiscal Policy

Reduce G, increase T budget

surplus personal disposable

income and business after-tax income

falls dampening effect on C and I

AD falls less pressure on GPL

Inappropriate for cost-push inflation

Time lag

Unpredictable effect of taxes on C

and I

Poor may suffer more: need subsidies/ supplementary schemes from

government

Cannot estimate how much to

decrease AD by

Market Policies

- Manpower

policy

- Pro

competition

policy

Improve efficiency of labour markets

so that any given level of AD

associated with lower level of

unemployment

Better matching of workers to jobs,

reducing labour market imbalances or

bottlenecks

Reduce monopoly / market power of

unions and businesses less able to

push up wage rates ahead of average

productivity increases + reducediscretionary power of large firms to

raise prices

- Business: antitrust laws, remove

existing legal restrictions upon entry

reduce / eliminate restrictions

Administration unlikely to undertake

vigorous antimonopoly / antiunion

stance

Large firms enjoy EOS and high rate

of technological progress

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upon foreign imports

- Labour: anti-monopoly laws to

unions, decentralization of collective

bargaining, link portion of wages to

profits

wage more flexibledownward

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Wage-price

Policies

- Wage

guidepost

- Price

guidepost

- Wage / prize

freeze

Wage rates rise with rat e of increase

in labour productivity

Prices should change to compensate

for changes in unit labour costs

Something like price ceiling

Workability and compliance: business

and labour leaders have to forgo the

goals of maximum profits and higher

wages little voluntary cooperation

Strong economic incentives could

develop to evade controls

Effect wage-price controls interfere

with allocative function of price system

Welfare

benefits

Remove benefits people more

willing to be employed increase

productive capacity of country

Need to ensure that people are equipped

with skills / are able to find jobs

quickly (frictional and structural

unemployment)

Need to ensure jobs are available in the

first place

R+d,

education andtraining

Increase productivity increase AS Long run measure

1) Priorities of goals: low inflation rate SR: lower rate of economic growth and higher level of

unemployment

2) Economic philosophy government subscribes to: rely on free market / intervention: dependent

on degree of government intervention considered necessary


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CHAPTER VII

FINDINGS

Some of the major findings are:

Inflation is a sustained increase in the general level of prices for goods and services.

When inflation goes up, there is a decline in the purchasing power of money.

Variations on inflation include deflation, hyperinflationand stagflation.

Two theories as to the cause of inflation are demand-pull inflationand cost-push

inflation.

When there is unanticipated inflation, creditors lose, people on a fixed-income lose,

"menu costs" go up, uncertainty reduces spending and exporters aren't as

competitive.

Lack of inflation (or deflation) is not necessarily a good thing.

Inflation is measured with a price index.

The two main groups of price indexes that measure inflation are the Consumer

Price Index and the Producer Price Indexes.

Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large

role in the Fed's decisions regarding interest rates.

In the long term, stocks are good protection against inflation.

Inflation is a serious problem for fixed income investors. It's important to

understand the difference betweennominal interest rates and real interest rates.

Inflation-indexed securities offer protection against inflation but offer low returns.

Implication or impact of Inflation

The impact of inflation on individuals and businesses depends in part on whether inflation

is anticipated or unanticipated:

o Anticipated inflation: When people are able to make accurate predictions of

inflation, they can take steps to protect themselves from its effects.

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o Unanticipated inflation: When inflation is volatile from year to year, it becomes

difficult for individuals and businesses to correctly predict the rate of inflation in

the near future. Unanticipated inflation occurs when economic agents (i.e. people,

businesses and governments) make errors in their inflation forecasts.

Impact of Inflation on Savers:

Inflation leads to a rise in the general price level so that money loses its value. When

inflation is high, people may lose confidence in money as the real value of savings is

severely reduced. Savers will lose out if nominal interest rates are lower than inflation

leading to negative real interest rates. For example a saver might receive a 3% nominal rate

of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real

rate of interest on savings is -2%.

Inflation Expectations and Wage Demands

Inflation can get out of control because price increases lead to higher wage demands as

people try to maintain their real living standards. Businesses then increase prices to

maintain profits and higher prices then put further pressure on wages. This process is

known as a wage-price spiral.

Arbitrary Re-Distributions of Income

Inflation tends to hurt those employees in jobs with poor bargaining positions in the

labour market - for example people in low paid jobs with little or no trade union protection

may see the real value of their pay fall. Inflation can also favour borrowers at the expense

of savers as inflation erodes the real value of existing debts.

Business Planning and Investment

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More generally, inflation can disrupt business planning. Budgeting becomes difficult

because of the uncertainty created by rising inflation of both prices and costs - and this may

reduce planned capital investment spending. Lower investment then has a detrimental

effect on the economys long run growth potential

Competitiveness and Unemployment

Inflation is a possible cause of higher unemployment in the medium term if one country

experiences a much higher rate of inflation than another, leading to a loss of international

competitiveness and a subsequent worsening of their trade performance.

CHAPTER VIII

CONCLUSIONS AND RECOMMENDATION

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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. 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. 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.

Given this conclusion, the study makes three recommendations:

1. To establish a mechanism to continuously monitor price developments in India to

ensure harmonization of domestic regulated prices (e.g. petroleum products etc.).

2. To commence studies for examining the implication of increasing the level of

capital mobility between both countries.

3. To refine monetary policy formulation. Presently, monetary policy is geared toward

maintenance of price stability

BIBLIOGRAPHY

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Retrieved 03 12, 2012, from

http://www.financialexpress.com/news/nepalsinflationsoarsto13.7pct/441254/


http://www.clevelandfed.org/research/Inflation/World-Inflation/Bank, N. R.


http://red.nrb.org.np/publications/special_publication/Special_Publications--

Inflation%20in%20Nepal.pdf

Bank, N. R. (2012, 03 15). Retrieved from www.nrb.org.np

Mankiw, N. G. In Macroeconomics. Pearson.

ACKONWLEDGEMENTS

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We would like to extend our sincere gratitude to Ace institute of management for designing

term paper as requirement for the partial fulfillment of Masters of business Administration

(MBA). This report has been prepared on the topic

We are grateful to Mr. Partap Basnet lecturer (Macro Economics) Ace Institute of

Management for providing necessary guidelines for preparation of this report.

We would also like to thanks all the teachers, family and friends for their support during

the period of report preparation.

Finally, we would like to thank all whom we have forgotten to mention who help us

directly or indirectly.

Thank you all.

Sincerely,

Sudarshan Paudel

Sanjit K.C

Madhu Sudhan Koirala

Santosh Kunwar

Sudhir Shrestha

Ace Institute of Management

Executive summary

Inflation is a word that makes people, especially the leaders, policy makers, business

planners and consumers concerned and scared. High inflation is an invisible negative

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economic factor that causes erosion in workers' savings and savers' buying power diverts

resources from productive investment and virtually slows down the economy. Economists

use the term "inflation" to denote an ongoing rise in the general level of prices quoted in

units of money. The magnitude of inflation, the inflation rate, is usually reported as the

annualized percentage of growth of some broad index of money prices. Inflation thus

means fall in the overall purchasing power of the monetary unit. Inflation rates vary from

year to year, from country to country and from currency to currency. When the inflation

rate is very high, it is referred to as "hyperinflation'. Generally when the inflation rate is

running at "double digit", it reflects as a sign of hyperinflation and negative inflation is

known as "deflation".

Inflation can be defined in simple language as a rise in the general price level and therefore

a fall in the value of money. Inflation occurs when the buying power is higher than the

output of goods and services available in the economy. As to whether the fall in value of

money will affect the functions of money depends on the degree of fall. Basically, it refers

to the availability of goods and services, resulting in higher prices. Inflation can be

measured in term of percentage. The two basic indexes are used in measuring inflation.

They are producer price index (PPI) and consumer price index (CPI) which is also known

as the cost of living index.

There are different types of inflation on the basis of inflation coverage and scope point of

view. A high inflation rate is highly undesirable because it has negative and far reaching

consequences on the economy. Therefore, the government, its policy makers, the central

bank of any country must diagnose its causes in depth by implementing pragmatic and

effective policies to control inflation. There are many factors responsible for inflation in the

economy. The causes of inflation vary from country to country and from time to time and

the causes are summarized as: (1) over-expansion of money supply (2) increase in

population (3) deficit financing budget (4) expansion of bank credit (5) high indirect taxes

(6) black money (7) poor performance of the agricultural sector (8) higher government

administrative costs (9) rise in the production and labor costs (10) rise in energy-petrol,

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diesel, CNG and electricity costs (11) weak currency and (12) infrastructural and foreign

currency bottlenecks.

The responsibility of controlling and containing high inflation rate falls, for obvious

reasons, on the government which is the prime policy maker for any country. Governments

of different countries-developed, developing and underdeveloped, take various measures to

control inflation through their fiscal policies. Fiscal policy of any country thus plays a very

significant role in controlling inflation, reducing unemployment by creating new

employment opportunities, augmenting the national economy by stabilizing the price level,

consumption level, income distribution level and intensifying the process of capital

formation. Preparing economic-friendly fiscal policy is the most important and vital job of

a government and acute diligence and prudence need to be applied while framing the fiscal

policy.

Table of Contents

CHAPTER I......................................................................................................... 1

Introduction ...................................................................................................... 1

1.2. How Inflation are Measured? .................................................................. 1

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1.3. Causes of Inflation ................................................................................. 2

CHAPTER II........................................................................................................ 3

Methodology ..................................................................................................... 3

Literature Review ........................................................................................... 3

CHAPTER III....................................................................................................... 4

Inflation in Nepal............................................................................................... 4

3.1. History of Inflation ................................................................................... 4

3.2. Historical Perspective of inflation in Nepal............................................... 5

3.4. Nepal-Inflation Average: .......................................................................... 7

3.5. Inflation in Nepal..................................................................................... 7

Inflation Measure for Nepal............................................................................... 9

chapter V ........................................................................................................ 11

INFLATION AND THE WORLD ECONOMY .......................................................... 11

CHAPTER vi..................................................................................................... 14

POLICIES TO CONTROL INFLATION .................................................................. 14

CHAPTER VII.................................................................................................... 18

Findings .......................................................................................................... 18

CHAPTER VIII................................................................................................... 20

CONCLUSIONS AND RECOMMENDATION ......................................................... 20

BIBLIOGRAPHY ................................................................................................ 21

Executive summary ........................................................................................ 23

Table of Contents ............................................................................................ 25

POKHARA UNIVERSITY ..................................................................................... 28

ACE INSTITUTE OF MANAGEMENT ................................................................... 28

Report on ..................................................................................................... 28

DYNAMICS OF INFLATION ................................................................................ 28

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Submitted To ............................................................................................ 29

Mr. Pratap Jung Basnet ............................................................................. 29

Instructor, Macro Economics ..................................................................... 29

Submitted By: ........................................................................................... 29

Madhu Sudan Koirala ................................................................................ 29

Sanjit K.C.................................................................................................. 29

Santosh Kunwar ........................................................................................ 29

Sudarshan Paudel..................................................................................... 29

Sudhir Shrestha ........................................................................................ 29

LIST OF FIGURES Page no

Figure 1 History of Inflation...............................................................................5

Figure 2 Trend of Inflation in Nepal...................................................................6

Figure 3 Nepal-Inflation Average.......................................................................7

Figure 4 The Year-on Year (y-o-y) inflation figure (Source: NRB)........................8

Figure 5 LRAS and Inflation.............................................................................15

LIST OF TABLES page no

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Table 1 Policies to control inflation..................................................................16

POKHARA UNIVERSITY

ACE INSTITUTE OF MANAGEMENT

Report on

DYNAMICS OF INFLATION

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Submitted To

Mr. Pratap Jung Basnet

Instructor, Macro Economics

Submitted By:

Madhu Sudan Koirala

Sanjit K.C.

Santosh Kunwar

Sudarshan Paudel

Sudhir Shrestha

March, 2012

29

Documents

Dynamic of Inflation Report-1