Hari Sharma, an alumnus of South Asian University writes for the Kathmandu Post

– In macroeconomics, inflation is among the most researched topics because it has serious consequences for growth, poverty and income distribution. Even a modest level of inflation can retard economic growth by inducing price distortion, lower savings and investment, capital outflow and encourage black marketing all of which have long-term impacts on economic efficiency. The inconsistent characteristics of inflation are harmful for economic growth as they promote uncertainty among economic agents who then are unable to take optimal decisions. Sluggish economic growth and rising prices of necessities have been features of the Nepali economy for the last decade. Inflation has been hovering at ten percent per annum since 2006/07 despite its underdeveloped financial market.
Nepal’s economy is characterised by a fixed exchange rate with Indian currency and a heavy reliance on imports. Inflation, thereby, is not only affected by domestic factors but more so by external ones. The current level of output and employment in the economy are domestic factors that affect inflation. Due to a rise in economic activity, the rate of unemployment goes below a certain threshold and pressure from workers to increase wages leads to inflation. To control inflation of this nature, the central bank is supposed to pursue a contractionary monetary policy, either by reducing the supply of money or by increasing short-term interest rates, which is expected to influence the behaviour of commercial banks and economic agents by determining the rate at which they can lend and borrow. When the unemployment rate falls below the threshold level, a rise in interest rates will affect economic activities by increasing the cost of funds, thereby increasing the unemployment rate until the rate of inflation is stabilised.
The effectiveness of a monetary policy to control inflation, however, is determined by the structure of the economy. And the success of interest rate or credit policy depends on the transmission of policy into economic activities by changing the behaviour of banks and investors. Many other factors such as the degree of competition among commercial banks, substitutability and the availability of different forms of finance, de-facto independence and the credibility of the central institution and market expectations affect it. It is obvious that in a well-developed financial system as in Europe and the US, the transmission of the monetary mechanism is always smooth and effective. It can put a dent in the high rate of inflation. But for Nepal, whose financial system is still in the early stages of development and quite immature, the transmission is often very slow, low and incomplete. In fact, such policies may even be futile as changes in interest rates of the central bank do not affect the lending rate of commercial banks, and hence economic activities and the rate of inflation.
The menu of financial assets available to private savers in Nepal is often limited to cash, demand deposit, time deposit and government securities. And a private individual has limited access to commercial banks. In addition, commercial banks are operated under oligopolistic market structures and have succeeded to preclude themselves from the central bank’s policy. Therefore, the central bank’s monetary policy remains ineffective even though the Nepal Rastra Bank (NRB) has not given much thought to controlling inflation through short-term interest rate in the last seven years.
For a small economy like Nepal, the more open an economy the greater the impact of foreign prices on domestic price levels, either through an increase in domestic currency—which makes imports dearer—or a rise in the price of imports. As a price taker in the international market, the exchange rate is an additional channel, apart from the level of unemployment, which affects general price levels in Nepal. When the exchange rate increases, some imports or close substitutes that constitute the consumer price index immediately increase the price of goods purchased in foreign currency and expressed in local currency. Importers adjust their prices in local currency to purchase the same goods, and in turn, increase inflation. Second, the manufacturers of local goods need to import inputs in foreign currency. An increase in exchange rates lead to a rise in the prices of such inputs. The importers then transfer these increased prices to local producers who in turn charge more from consumers in order to maintain profits. Thus, an initial increase in exchange rates, transmitted to consumer prices, generates inflation.
Nepal uses a fixed exchange rate system to reduce domestic inflation by fixing its currency to the currency of its major low-inflation trading partner India to help maintain price stability. But the fixed exchange rate also means that Nepal is inheriting the inflationary experience of the rest of the world, in particular the Indian currency to which it is fixed. In Nepal, with its GDP size of $17.921 billion (2010 estimate), imports alone account for 18 percent of its GDP which is $3.229 billion (2008). Even countries with well-developed financial systems are susceptible to external shocks via excessive reliance on imports. So Nepal is not an exception.
However, if it were a flexible exchange rate system, the central bank could intervene in the currency exchange market to control inflation by decreasing exchange rates against foreign currency. The exchange rate volatility would also provide some insulation against external shocks and help stabilise domestic inflation under the flexible exchange rate system.
Under a fixed exchange rate regime, monetary institutions cannot use either of the instruments—interest rates, credit channels and exchange rates—to stabilise prices. They do not have monetary policy independence too. So, the monetary policy of NRB will remain ineffective in targeting inflation under the current economic structure. NRB, should therefore do the needful to develop an alternative policy instrument applicable to Nepal instead of relying on the monetary policy instrument prescribed by the developed world.
And the objective of stabilising the economy through sustained growth is only possible if there exists a high level of coordination among the Ministry of Finance, the Ministry of Commerce and Supplies and NRB.

Sharma is a graduate in MA Development Economics from South Asian University, New Delhi