MONEY AND INFLATION: A REVIEW TO A NEPALESE

CONTEXT

INTRODUCTION:
Money and Money Supply
Money is the stock of assets that can be readily used to make transactions. Economists,
however, have a language all their own when it comes to money. They define it as
something that serves as a medium of exchange, a unit of accounting, and a store of
value. Money is a medium of exchange in the sense that we all agree to accept it in
making transactions. As a unit of accounting, money provides a simple device for
identifying and communicating value. Money serves as a store of value in that it allows
us to store the rewards of our labor or business in a convenient tool. (Shmoop Editorial
Team, 2008)
Money supply is the quantity of money available in the economy. It is the entire stock of
currency and other liquid instruments in a country's economy as of a particular time. The
money supply can include cash, coins and balances held in checking and savings
accounts. (Investopedia US, 2014) .
The various types of money in the money supply are generally classified as "M"s such as
M0, M1, M2 and M3, according to the type and size of the account in which the
instrument is kept. Not all of the classifications are widely used, and each country may
use different classifications. M0 and M1, for example, are also called narrow money and
include coins and notes that are in circulation and other money equivalents that can be
converted easily to cash. M2 included M1 and, in addition, short-term time deposits in
banks and certain money market funds. (Investopedia US, 2014)
Forms of money supply are decided by Nepal Rastra Bank (NRB), central bank of the
country, which is as:

M1 or Narrow Money Supply

It is a category of the money supply that includes all physical money such as coins and
currency; it also includes demand deposits, which are checking accounts. M1 is used to
quantify the amount of money in circulation. M1 is a very liquid measure of the money
supply, as it contains cash and assets that can quickly be converted to currency.
M1=Currency + demand deposits, travelers checks, other checkable deposits

M2 or Broad Money Supply

It is a category within the money supply that includes M1 in addition to total time-related
deposits, savings deposits, and non institutional money market funds. M2 is used when
looking to quantify the amount of money in circulation and trying to explain different
economic monetary conditions. In Nepal, Broad money supply, M2 has a lagged and
temporary effect on inflation. However, compared to other factors such as Indias
inflation and international oil prices, M2 has a minor role in contributing to Nepals
inflation.
M2= M1 + small time deposits Money supply is considered as a major contributor to
inflation.
Monetary policy is the control over the money supply. Monetary policy is conducted by a
countrys central bank. In Nepal, Nepal Rastra Bank serves as a central bank. There are
different lags on the effect of money supply on inflation, savings deposits, and money
market deposit accounts.

INFLATION:
Inflation means a sustained increase in the aggregate or general price level in an
economy. Inflation means there is an increase in the cost of living. (Economics Help,
2014).It is the percentage increase in the average level of prices. When inflation occurs,
the buying value of a currency unit erodes, meaning that a person needs more money to
buy the same product.

The inflation rate in Nepal can be illustrated with the trend shown in the graph below:

(Source: http://sapkotac.blogspot.com/2013/03/new-inflationary-normal-in-nepal.html)

The figure shows the monthly change in inflation, which is an aggregate measure of the
change in prices of goods and services, in the last three years and the first seven months
of FY2013 (ending 15 July 2013).

CAUSES OF INFLATION IN NEPAL:

The causes of inflation in our country considering the current situation are as follows:
1. Political Riot: The volatile political situation in Nepal played a vital role in the
increment of all commodities. The impractical government amended rules and
regulation made the situation even worst. The unclear motive of government
regarding economic sector has also caused the living standard of the normal
citizen to degrade.
2. GDP and Per capita income in decreasing trend but increase in price level:
The GDP of Nepal is in decreasing trend whereas the price level is increasing
yearly. As per the National Income view, the contributions to GDP have major
impact on the economic aspect of the country.
3. Growing concrete jungles: At present time all we see around us are concrete
buildings. Fertile lands have been used for real estate purpose. If this trend goes
on for a long time, it can be clearly predicted that the inflation rate is undoubtedly
going to rise especially for food items.
4. High labor cost: The prices of items are also high because of the labor costs that
are very low mainly in terms of people who get paid on daily basis.
5. Price of petroleum products: Price of petroleum products has been adjusted
several times on the higher side. Such adjustments helped pushing the cost of
freight and carriages and cost of other goods and services.
6. Transmission through trade: Furthermore, rising inflation in India is transmitted
in Nepal through trade, which is one of the significant factors of increasing
inflation rate of Nepal.

7. Unnoticed causes:

Policy manipulation

Alternative to central banks

In addition, rate of per capita GDP in relation with money supply is also a cause of
inflation in Nepal. The growth rate of money supply if is faster than the growth rate of
per capita GDP which implies that there is more money in the economy as compared to
the production level of goods and services. Thus, rapidly increasing money supply might
be another cause of inflation in the country.
Also, government expenditures which are usually financed by revenues from tax and
non-tax sources may not be adequately financed by these sources in such scenario
country faces budget deficit. In order to finance the growing budget deficit, the
government has borrowed from domestic as well as foreign sources. The growing amount
of external borrowing helps to increase money supply and thus the increase in inflation.
Similarly, internal borrowing has also been used as another source of financing
government budget deficit. Most of the internal borrowing comes from the banking sector
which reduces the availability of the funds to the private sector which might also create
inflation.

INFLATION AND MONEY SUPPLY:

Various theories explain the relationship between money supply and inflation. A simple
theory that links the inflation rate to the growth rate of the money supply is quantity
theory of money.
The quantity theory of money states that there is a direct relationship between the
quantity of money in an economy and the level of prices of goods and services sold.
According to QTM, if the amount of money in an economy doubles, price levels also
double, causing inflation (the percentage rate at which the level of prices is rising in an
economy). (Investopedia US, 2014)

The relationship is expressed as:

MV=PT (Money Supply x Money Velocity=Price Level x Transactions)
Velocity is the rate at which money circulates. It is the number of times the average rupee
changes hands in a given time period. The Velocity and Transactions are considered to be
constants, so according to this explanation supply and prices have a direct relationship.

Where,
P

= price of output (GDP deflator)

= quantity of output (real GDP)

P Y

= value of output (nominal GDP)

The quantity equation
M V = P Y
follows from the preceding definition of velocity.

The quantity theory of money implies

Countries with higher money growth rates should have higher inflation rates.
The long-run trend behavior of a countrys inflation should be similar to the longrun trend in the countrys money growth rate.

Changes in money supply are often used to try and control inflationary conditions. When
a region is trying to lower inflation, central banks will generally lower lending rates and
increase interest. When inflation drops below a target level, these standards are generally
relaxed in an attempt to stimulate the economy.

SUGGESTIONS TO MINIMIZE INFLATION IN NEPAL:

Analyzing the current inflation situation of Nepal, there is a need for some policy
initiations. Such initiations will certainly show positive sign in Nepalese economy and
businesses. They are stated as follows:
1. Control on food price inflation: Rising inflation in Nepal has been mainly driven
by food price inflation. Thus, price hiking in food products can be solved by
providing subsidies and following the policy of protectionism in food products.
2. Structural changes in economy: The changing pattern of inflation may reflect
structural changes in Nepals economy, for example, rising imports as a share of
GDP, and policy makers should be alert to these changes as they may cause
inflation to be more volatile and persistent.
3. Fiscal policies intervention: Tightening fiscal policies such as taxation,
expenditure and public borrowing are seem to be essential to control current
inflation rate rising.
4. Covering supply side: 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.
5. Implementation of government's policy: Due to various political reasons, the
announcement of policies and plans is being delayed. Timely announcement of
the government's policy, program and budget for the fiscal year should be ensured
to control inflation to the some extent.

CONCLUSION AND REFERNCE:

Conclusion:
In Nepalese context, quantity theory of money is partially applicable. The most part of
the Supply of money increased by increase in GDP in Nepal is going towards imports
from India and China. We are a net importing country including the basic commodities
imports; therefore we cannot do away with inflation of other countries. So, we will have
to take into consideration the inflation factor of supply side (inflation in India, China and
international commodity price rise). In effect, Nepali economy is destined to have high
inflation, and with it peoples lives will get harder each year. Unless the market
distortions are dismantled, unproductive spending are checked, and a sound
macroeconomic framework (that doesnt depend on remittances for sustenance) is
created, we will continue to have a high inflationary normal, i.e. high inflation will be a
new normal and people will experience continued erosion of purchasing power. We also
finance our budget deficit with borrowing which can pose additional problem for
inflation.
In a nutshell, money supply is highly responsible for inflation in our country. It doesnt
matter whether it is cause due to uneven per capita growth rate of GDP in relation with
money supply or through budget deficiencies causing inflation through external or
internal financing. Inflation is a matter of concern for government as well as public.
Some level of inflation is consider good for economic growth but in Nepalese context, as
a developing nation inflation must be under control through various policy invasions.

References:
Economics Help. (2014). Economics Help. Retrieved January 20, 2014, from Econonic
Essays on Inflation: http://www.economicshelp.org/macroeconomics/inflation/definition/
Investopedia US. (2014). Investopedia US. Retrieved January 23, 2014, from Investing:
http://www.investopedia.com/articles/05/010705.asp
Investopedia US. (2014). Money Supply. Retrieved January 22, 2014, from Dictionary:
http://www.investopedia.com/terms/m/moneysupply.asp
Shmoop Editorial Team. (2008, November 11). Money: The Economic Definition.
Retrieved January 26, 2014 from http://www.shmoop.com/money-banking/economicdefinition.html

Thank you

ECONOMICS TERM PAPER

MONEY AND INFLATION: A REVIEW TO A NEPALESE
CONTEXT

Submitted To
Niranjan Basnet
Course Facilitator, Macroeconomics
School of Management

Submitted By
Sunaina Shrestha
Roll: 32
2nd Semester

In Partial Fulfillment of the Requirements for the degree of

Master of Business Administration (MBA)

August, 2014