OVERVIEW

In this article, the causes

of inflation, as well as
the theories of inflation,
have been discussed.

Shreya Karki

INFLATION IN NEPAL
What causes it?
 Inflation In Nepal
The inflation rates in Nepal have been a forever controversial topic. Inflation refers to the
economic condition where there is an autonomous increase in the value of goods and products.
The great Inflation in May of 1966 and May of 1967 to these 3 years of the aftermath of the
covid has certainly raised thousands of questions and dissatisfaction among the citizens of the
country, the investors, shareholders, loan takers, and businesspeople. The inflation rate for
consumer prices in Nepal moved over the past 56 years between -3.1% and 19.8%. For 2021, an
inflation rate of 4.1% was calculated by Nepal Rastra Bank. (Central Bank of Nepal).

During the observation period from 1965 to 2021, the average inflation rate was 8.0% per year.
Overall, the price increase was 6,849.74%. An item that cost a hundred rupees in 1965 cost
6,949.74 rupees at the beginning of 2022.
The average inflation rate of Nepal is 8.03% from 1964 until 2023. The highest recorded was
30.42 in May of 1966 and the lowest being -11.54% as of May of 1967. The budget
shortcomings, hike in oil prices, the loss of currency value (Collapse of Currency), low-interest
rates, and problems in the monetary policy. The 1970s was a period of strong trade union
power, which enabled a wage spiral in the economy too.
 Consumer Price Index
The Consumer Price Index is a measuring index that calculates the average change in a basket
of goods taken as a reference over time. The higher the CPI, more will be the inflation. The
average is calculated as 7.955 from the year 1965 to 2023.
It uses the Laspeyres formula which is calculated by working out the cost of a group of
commodities at current prices, dividing this by the cost of the same group of commodities at base
period prices, and then multiplying by hundred.
 Theories of Inflation.
1. Quantity Theory of Money (QTM)
- Polish mathematician Nicolaus Copernicus in 1517 formulated this theory
Economists Milton Friedman and Anna Schwartz popularized this theory after the
publication of their book, "A Monetary History of the United States, 1867-1960," in
1963.

The Quantity Theory of Money states that if the money supply increases in the
market, so does the price level. To better understand this concept, let us look at how
money supply is the leading factor in the situation. An increased money supply in the
country means that the value of money decreases. So, to balance out the situation,
the price of goods has increased too. The same thing that we could buy with 1
currency now requires more money. This theory became more popularized in the
1870s and 1980s when monetarism was on the rise.

Irving Fisher discovered the calculation formula; it is also known as “Fisher’s

Equation”. This formula helps in calculating the inflation or deflation in the market.
(M)(V) =(P)(T)
where:
M=Money Supply
V=Velocity of circulation (the number of times money changes 
hands)
P=Average Price Level
T=Volume of transactions of goods and services

2) Rational Expectation Theory

The Rational Expectation theory was put forward by John F. Muth in his paper”
Rational Expectation and The Theory of Price Movements. The Rational Expectation
theory states that humans are rational beings, and they make decisions on three bases:
human rationality, the information provided to them, and their experience. They can
expect market situations and make decisions according to them. It is they that
influence the market change too. They use the information that they have in hand,
their decision may also change if the latest information is added. Economists use this
 theory to explain the anticipated inflation rates. This doctrine is used to evaluate the
accuracy of inflation forecasts.

The Expectation Augmented Phillips Curve

The Expectation Augmented Phillips Curve (originally based on A.W. Phillips’ work on the
statistical relationship between unemployment and inflation) can show the role of rational
expectations.

Source: coorporatefinanceinstitute.com

3. Demand-Pull Inflation
Demand-pull inflation simply means the increase in the price of goods and services as the demand for
people increases. It refers to the fact that the demand is greater than the supply at the moment and so
 to keep a balance, the companies and industries increase the prices of the goods. This creates inflation
in the country. It is caused by the introduction of new goods and technology, more consumption in the
households, change in supply, increased purchasing power of consumers, rise in export and fall in
imports, and many more. The difference between Quantity demanded (QD) and Quantity supplied
(QS) is used to calculate the excess demand.

4. Cost Push Inflation

Inflation is caused by the increase in the prices of goods and services i.e., Quantity Supplied is
costlier. The increase in the supply of goods can be caused by factors such as an increase in wages, an
increase in the price of raw materials, an increase in production costs with other more too. For
example, the shoe company might increase the prices of shoes if the price of the leather is also
increased. Since the demand for the shoes remains the same, the consumers are hence compelled to
buy at high rates for the same shoes. This creates inflation in the country. Consumers start to lose
their capacity to buy. The same thing occurred in the 1970s when the OPEC countries increased oil
prices, since many products required oil to run and the demand was the same, a global crisis took
place.

The other factors that have significantly affected the economy of Nepal are:

I. The Covid Crisis: The pandemic has caused a rise in the global inflation rate.
The supply and demand have not been at equilibrium. The Covid-19 crisis started in
2020, and the demand for some goods increased whereas the supply decreased. E.g.:
masks, sanitizers, gloves, handwash. The supply chain between countries was disrupted
since the transportation areas were shut down. Not only this but a lot of companies and
businesses were shut down in Nepal. It lowered the supply quantity in the country but
since the demand remained constant, the price of goods and products spiked. The
companies too had to spend more on the manufacture of goods, so it only seemed
reasonable to increase the price of goods to make a profit. The nominal wages of the
workers increased whereas a loss was seen in their real wages. Due to the pandemic
situation, our currency’s value has also decreased significantly. When the country cannot
maintain equal supply and demand in the market, situations like this can occur. The
World Bank’s latest South Asia Economic Focus says that Nepal’s economy is projected
to grow by only 0.6 percent in 2021 from an estimated 0.2 percent in 2020 as lockdowns
disrupt economic Activity.
II. The Oil Crisis: This is a problem faced recently by the entire world including
Nepal. Due to the ongoing war between Russia and Ukraine, the oil supply has been
reduced considerably. The OPEC countries are not increasing the supply whereas on the
other hand, the demand for oil remains the same. Due to high demand but less supply, the
producers have increased the price of oil in the market. In the 1970s too, the oil crisis was
the leading factor contributing to inflation. Transportation is the area that requires oil
consumption at the most so when the oil prices rise, all the products related to
transportation will experience higher costs. Higher oil prices lead to higher production
costs and a decrease in the living standard of people. Higher oil prices will lead to an
improvement in the current account position of oil exporters like OPEC countries. It will
lead to a deterioration in the current account position of oil importers.