Introduction
Inflation, in general is the situation, in which the price of goods and services increases with
the decline in purchasing power of money. It measures changes in the price level. So it is
normally associated with high prices causing decline in purchasing power of money. But it
has the nature of appreciable and persistent movement to increase. Neo-classicist opines it
as a natural monetary phenomenon of economy. Milton Friedman has conceived inflation
as a steady and sustain rise in prices. In terms of Keynesian analysis, excess demand over
the available supply is the hallmark of inflation thus showing the condition of economic
disequilibrium and rise of price would merely be the symptom in indicating its' existence.
On the other, A. C. Pigou takes inflation as a situation where money income is expanding
more than in proportion to output by the productive agents. So, we can conclude from
above definitions that inflation is basically an economic phenomenon, which originates
within the economic system and is fostered by the interaction of economic forces. It is a
situation where excess demand is generated because of excess money supply as a cause
and in effects the general price rise. Then, inflation seems to be a function of money supply
with positive relation.
Causes
The inflationary pressure is seemed a phenomenon ushered in the economy due to demandgenerated
and supply-generated effect. If an increase in effective demand is unmatched by
total supply available at the current price, it will exert its' influence in raising prices which
is termed as demand-pull inflation. From the angle of production process, if rise in price is
initiated by the increase in factor cost, then it is cost-push inflation. We can broadly
categorize the effect that usually give rise to inflation into two aspects, i. e. the demand
side and supply side of economy.
1. Demand generated inflation
We consider on those factors that lead to increase demand pushing-up price and thus
exerting inflation in the economy. All these factors create excessive demand over the
inadequate supply in the economy. Deficit budget is a major factor, which is aiming
at spending more than the government's revenue. The government tries to meet its
deficit budget through borrowings from domestic and external sources. Domestic
borrowings include borrowings from the public and banking sector, particularly
overdraft from central bank. An excessive overdraft facility enjoyed from the central
bank increases supply of money, which ultimately leads to rise in general price level.
As such other borrowings are collected and government starts to invest on social
overheads, it takes long time to outcome returns from such sectors on one hand and
puts immediate pressure to push-up effective demand of economy on the other. Thus,
increase in money supply and pressure on demand results in widening equilibrium
forces of economy causing increase in price of goods. High volumes of credit flow to
income level of people leads to increase in demand. As a result, the existing capacity
and services may not be adequate to satisfy the demand and prices have a tendency to
rise following excess demand. Shortages of goods due to natural calamities like
flood, erosion, earthquakes etc. leads in scant supply of goods and forces to rise in
price ultimately as to discourse demand. Increase in prices of import-based
commodities in international market, low productivity on the ground of high
population growth rate etc. are other factors in putting pressure on demand and
weakening supply capacity. Thus, there will be gaping and fall in supply strength to
meet such excess demand. So, all these factors causing high level in outflow of
money following undersupplied goods or say a condition where too much money
chasing a few goods creates inflationary pressure in the economy.
2. Supply – generated inflation
In the supply front of economy, inflation occurs mainly due to increase in cost of
production. A number of factors are responsible to increase the cost of production
pushing-up prices and finally making rise in the general price level. Cost of
production goes up when the prices of raw materials and wages increase, imposition
of taxes, increase in custom duties, devaluation of domestic currency, depletion of
natural resources, growing cost of factor of productions and increase in profit margin
for the entrepreneurs. Due to increase in cost of production, it increases the price of
goods on one hand and need to curtail the size of output at the given level of
investment on the other. Then supply volume is downsized. Then, a divergent
tendency from the point of equilibrium arises with severe footstep in the economy.
Effects
Economists have categorized four different types of inflation: creeping (up to 3 percent),
walking (3-6 percent), running (6-10 percent) and hyperinflation (galloping more than 10
percent)
Minimum rise in general price level is considered to be beneficial for promoting economic
growth of the country. Creeping inflation is thought to be an ideal rate usually for
developing economies and paves the way to boost up economic activities. Walking
inflation too have positive impact in the economic growth if it remains within the given
policy tie. There are many prominent economists who have a general consensus on the fact
that inflation as an indispensable condition for the economic growth. They agree upon the
fact that rising price level stimulates production, increases employment, facilitates a faster
rate of capital formation, creates demands for more production and thus benefits the nation
as a whole. So we can draw an inference that desired level of inflation in the early stages
activates developmental process in the economy. However, in a highly developed and
stabilized economy, creeping inflation may too distort the economic stability. Economists
still argue on which digit of an ideal rate, the rise in price level is better off for a
considerable growth. They also agree that it is more harm generating along with the direct
and indirect impact in various variables of economy and turn to economic evil if a high rate
of inflation beyond the capacity of the economy prevails. An excessive inflation creates
uncertainty in the economic atmosphere. Inflation has created a variety of social evils and
pushed economy into crisis, loosing peoples' confidence over domestic currency and
resulting to political catastrophe. People, having increase in money income with higher rate
in comparison to rise in price and other small portions of entrepreneur and businessman
usually get benefit with more and more earnings. But people with lower income level are
adversely stroke by the inflation, which tends to alter the existing distribution of wealth
and income and it further intensifies and widens the gap among people in the society.
Saving and investment, considered as the growth engine of the economy are discouraged
which leads to make reversal effect and existence of inflation gives contractionery pressure
over them and over production which creates negative impacts on employment
opportunities. It finally leads to yield social evils like robbery, crime, corruption, violence,
revolt etc deteriorating the social amity and harmony thus pushing economy into crisis.
That is why, it is Milton Friedman who has termed inflation as a taxing measure without
having specific legislative approval.
Control Measures
As inflation is resulted from demand and supply generating effect of economy, it is, after
all the supply of money accounted for the root cause of effecting the demand and supply
side of economy. It should be treated and maintained within the limit. These effects can be
downgraded by using various measures with the proper co-ordination of real and monetary
sectors of the economy. Though the effects of inflation depend upon the nature of
economic development (i. e. developed, developing, underdeveloped etc.), it is seen that
the coordinated efforts have been proposed to combat and overcome the problem of
inflation. Ultimately, there are two ways used as measures to restrain such problems. Fiscal
policy is a main measure to decrease the aggregate demand of economy. Fiscal measures
aim at influencing the buying power of consumer by imposing progressive tax, which
would result to curtail the size of disposable income, and then minimizes inflationary
pressure. It is taken as a stabilizing measure in the sense that the yield goes on increasing
with the increase in the income of people without discouraging productive capacity. On the
other hand, fiscal measure for financing government's deficit emphasizes on borrowings
from internal sources, which affects consumption pattern of people. However, it is
necessary to utilize such borrowings in productive sectors of the economy to return in
higher volume with faster rate and higher productivity. It helps to improve supply level and
match the demand. Reduction in unproductive administrative expenses also has a greater
impact to cure the effect of inflation.
Central bank as a monetary authority is primarily concerned with maintaining stability of
price and carries out other measures related to interest rate, exchange rate, external
account, liquidity management etc. The central bank, in practice, is doing its function of
conducting monetary policy. Since, monetary policy is a demand management policy, it
deals with the volume of money supply and such policy seems usually targeting inflation
as core an objective. So, monetary policy formulated by the central bank always aims at
keeping inflation within the desired level. But the effectiveness of monetary policy is
determined by the fact that to what extent the economy is monetized. A highly monetized
economy helps to ease and achieve targets. In the context of open and liberal economy, all
direct control measures are supposed to be against the market economy. Then, the central
bank certainly have limited tools in achieving monetary policy objectives. Nowadays,
Open market operation, interest rate/refinance rate and cash reserve ratio are considered as
major tools for an effective implementation of monetary policy with keeping inflation rate
into a handhold and being executed. These are the only indirect measures available to
control over the excess money supply. Keeping in view the supply of money, central bank
can issue government securities and its' own bonds as well in order to mop-up liquidity
from the market. Interest rate is another way to influence the cost of credit and determine
the supply of credit in the economy. But, since imposing interest rate is taken as
interference against the norms of market economy, it is fully deregulated in the context of
liberalization. Then, importance of refinance rate is increasing as a tool to influence credit
creation capacity of financial institutions. Altering reserve requirements of banks is also
being adopted as necessarily to balance money supply and to influence supply of money
and maintain liquidity at an ideal level.
Inflation measurement & consequences in Nepal
The most widely used indicators of measuring general price level are the Consumer Price
Index, Wholesale Price Index and the GDP deflator. Since different price indices behave
somewhat differently, the choice of a price index will affect the measurement of the rate
and degree of inflation. The first two indicators cover the prices of different group of
commodities and GDP deflator is used to calculate overall price movement by covering
entire aspects of economy.
Nepal Rastra Bank has been using consumer price index and wholesale price index to
measure the aggregate change in general price level. The goods for consumer price index
are being selected as representative items from the basket of goods. These items have been
assigned certain weightage and the weight is being determined through Household Budget
Survey conducted in every ten years. The consumption weightage used at present is based
on the Household Budget Survey 1995/1996. Though the consumer price index does not
represent the overall goods produced in the economy, it is assumed to represent almost of
the goods consumed by general people and their consumption pattern. Near about 300
commodities have been included and price is being collected on a weekly, fortnightly,
monthly, quarterly, half-yearly and yearly basis to trace the movement.
Rise in general price level is being a common phenomenon and containing inflation has
become a major challenge of monetary policy. Achieving inflation target is considerably
and heavily influenced by the other internal as well as external factors in the context of
Nepal. So, it should not be linked only with monetary policy formulated and implemented
so far by central bank. The expansionary fiscal policy, a major component that the
government is undertaking has evidenced in increasing inflation in Nepal. There is
growing demand for government expenditure to finance for basic infrastructure and
investment on such sector has a long gestation period to yield returns. Such investment on
social overhead is putting immediate pressure on aggregate demand of the economy in one
hand and the investment made through such borrowings has influenced the price level to
move upward in another hand. Inelastic supply of domestic output, particularly food
grains, in the ground of rapidly growing population is also being accountable for the rise in
price. Nepalese market is vulnerable to Indian policies imposed into Indian economy. Due
to long open border, Nepalese market is directly dominated from the large and fast
growing Indian economy and their pricing policy is being directly transmitted to Nepalese
economy through imported goods. Nepal is heavily dependent over capital goods and such
items include machinery and equipment needed for the development of industrial sector,
consumer durables and petroleum products are others being imported from the third
countries. Thus, as a result of price rise in international market, capital goods and
consumer-based imported goods and services are becoming comparatively dearer. Such
phenomena in comparison to marginal increment in export has widening trade deficit with
higher rate and pressuring on price. The rates of inflation and growth rates of money
supply over the last 15 years of period are presented in the following table.
Fiscal Year Inflation Rate Narrow Money(M1) Broad Money(M2)
2046/47 9.7 20.8 18.6
2047/48 9.8 14.5 19.5
2048/49 21.1 19.5 21.1
2049/50 8.9 22.5 27.7
2050/51 9.0 19.6 19.6
2051/52 7.7 15.7 16.1
2052/53 8.1 10.6 14.4
2053/54 8.1 5.4 11.9
2054/55 8.3 17.4 21.9
2055/56 11.4 13.1 20.8
2056/57 3.5 14.4 21.8
2057/58 2.4 16.1 15.3
2058/59 2.9 9.3 4.4
2059/60 4.8 8.6 9.8
2060/61 4.0 9.5 13.5
Source: Quarterly Economic Bulletins
Relationship between Money Supply & Inflation
0
5
10
15
20
25
30
2046/47
2047/48
2048/49
2049/50
2050/51
2051/52
2052/53
2053/54
2054/55
2055/56
2056/57
2057/58
2058/59
2059/60
2060/61
Inflation Rate Narrow Money(M1) Broad Money(M2)
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From the above table and graph, we can conclude that there is no proportional relation
between growth rate of money supply and growth rate of inflation measured by consumer
price index (CPI). But it can be seen that narrow money has stronger relation with the rise
in price than that of broad money.
As we see from the table, inflation rate has increased substantially in the year 2048/49 with
a rise of 21.1 percent indicating hyperinflation. Thereafter, inflation rate seems to coming
down and registered at 2.4 percent in the year 2057/58, the lowest rate observed since
2046/47. As Nepal Rastra Bank Act 2058 came into effect, Nepal Rastra Bank has started
to announce its' monetary policy for the general public every year. On the ground of past
activities and to facilitate projected economic growth made by government budget, Nepal
Rastra Bank has started to target a inflation rate in its' monetary policy after adequate level
of analysis. The inflation rate for the Fiscal year 2061/62 was targeted at 4.0 percent in the
monetary policy announcement. However, due to price hikes in petroleum products and
increase in VAT rate, the rate of inflation for the Fiscal Year 2061/62 has been revised and
estimated to remain at 4.3 percent level.
From the perspective of targets made in the economic development plans, the Eighth plan
had targeted 9 percent of inflation and the target was achieved with the average of 8.36
during the plan period but with highly fluctuating rate. Similarly Ninth plan (2054-2059)
had set target of 6.5 percent and the actual inflation rate remained at 5.7 percent. The
undergoing Tenth plan aims at limiting the rise on general price at 5 percent level and first
two years trend shows positive indication of keeping inflation within the targeted level.
If we go on scanning the root causes of inflation over the periods, a number of economic of
non-economic factors has influenced. In the year 2048/49, the Nepalese currency was
highly devalued against other convertible currencies. Nepal was in a regime of
implementing liberal economic policy and was in transitional period for the adjustment.
Thereafter, inflation rate has been decreasing up to 2054/55 and again increased by 11.4
percent in 2055/56. It was due to sharp increase in the price of food products. Another
major component in the past is found rise in price of the crude oil in the international
market from time to time and it has caused to affect adversely the general price level.
Deficit and expansionary budget of past several years perused and implemented by the
government has adversely hit in the price level. Seasonal adversity, dominance of nonmonetized
subsistence agriculture in the economy, disturbance of trade treaty in between
Nepal and India etc. are other factors found in general and responsible for escalating and
dampening effects on price. So, inflation in Nepalese economy is influenced by supply
shocks in the form of increase in domestic prices and / or imported prices. It can be
observed from the studies and past statistics that a number of factors may be internal or
external and economic or non-economic, have influenced in making rise to general price
level in the Nepalese economy and it is inferred that non-monetary factors have heavily
dominated the Nepalese economy relative to monetary factors in creating inflationary
pressure. However, inflation rates were contained under single digit with minor exceptions
in some years and have contributed more for development activities though having lesser
negative impact in the economy.
Concluding Remarks
Steady rise on general price level helps to increase profit ratio, increases saving, favours
capital formation and increase investment rate. It results in stimulating production and
110
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increasing employment opportunities, which accelerates economic growth. So minimum
level of inflation is desired for a developing economy. But, economic stability is adversely
affected and causes to rise crises and social evils in the economy if inflation goes beyond
control.
Monetary policy, the tool for dealing with money supply, is aiming at containing inflation.
For easing to fulfill the monetary targets, greater independence of central banks have been
soughted by academicians and economists and various central banks have achieved
independence with greater autonomy also. It is found more effective in attaining monetary
policy objectives for those with greater independence relative to other government-obliged
central banks. In the ground, NRB Act, 2058 has also come into effect and has granted
greater operational independence in formulating and executing its' policy instruments to
the central bank. It has set multiple objectives, with achieving price stability as a main as
stated in the preamble of Act.
The modern quantity theory of money deduces that the relationship between changes in
money supply and price level may not necessarily be proportional. In the context of Nepal,
it has been found the same as spelt out by modern quantity theory. A weak relation is
established in between money supply and inflation which is being experienced from
several years of past. A major objective of maintaining price stability has been constrained
by various structural and external factors and maintaining inflation within the control has
been a tough job to Nepal Rastra Bank. It is still becoming a challenging job to achieve
monetary targets with the implementation of indirect measures available in a liberal
economy and on the ground of existence of non-monetized subsistence agricultural sector.
Though exogenous factors are beyond the control and containing inflation is not solely
depending upon monetary policy, Nepal Rastra Bank have to made its' every effort which
is in hands to direct monetary variables towards easing and achieving monetary objectives.
It should monitor the movement of price and should keep it in desired motion through
using its' instruments. In the light of greater autonomy envisaged by new Act, NRB should
play its' effective role and would be more beneficial and achievable to attain macroeconomic
stability and policy objectives in better coordination with fiscal policy. It helps
economy to move apace with the desired economic growth.
References:
1. Sethi, T. T., Monetary Economics
2. Nepal Rastra Bank Samachar of different years
3. Various issues of Banking Prabardwan
4. http://www.adb.org, http://www.npc.gov.np
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