Article on Controlling Inflation

Breaking the bank

PRAKASH KUMAR SHRESTHA

Published on January 17, 2010

Recently, people have shown concern over the relatively high inflation in Nepal. After having low inflation averaging 3.6 percent from 2000 to 2005, inflation began to rise and reached levels as high as 13.2 percent in the fiscal year 2008/09, before sliding down to 10.5 percent in 2009/10. Recent data published by Nepal Rastra Bank (NRB) showed that as of mid-November 2010, annual inflation was 8.4 percent. In the news media, NRB has been blamed for not controlling inflation (see TKP Dec. 06, 2010, Fighting Inflation).

The NRB Act 2002 has clearly entrusted the NRB with the job of maintaining price stability and balance of payments (BOP) consolidation (external sector stability) through monetary policy, being fully influenced by the neo-classical notion of inflation determination. The belief that monetary policy can determine inflation is based on the Quantity theory of money. This is a closed-economy theory where money supply is proportionally related to price level if the economy is in full employment.

Another theory, the monetary approach to balance of payments in an open economy, shows the relation between money supply and balance of payments (BOP). In fact, both relations work when money is used solely for transaction purposes—where any finance motive is completely ignored. In other words, such a direct relationship only exists, for instance, when a helicopter drops a bounty of money in a place with no existing financial institutions. Though it may be common for people to blame the NRB after looking at the NRB Act 2002, a closer look at the determinants of inflation in countries like Nepal reveals that these notions of neo-classical inflation determination do not work. Criticism of the NRB is not enough to contain inflation.

In 2009, an expansion of monetary aggregates seems to have been accompanied by higher inflation, but a long-run relationship between the two is not strong in Nepal. Many empirical studies in Nepal have shown a weak relationship between money supply and price levels. Rather, inflation in Nepal is impacted primarily by inflation development in India on account of geographical proximity and the pegged exchange rate regime.

Despite the fact that inflation distorts price signals and leads to resource misallocations, Friedman’s hypothesis that inflation is always a monetary phenomenon may not be true—supply and cost play an equally important role in determining economic inflation. According to the heterodoxy school of thought, inflation does not necessarily have a monetary origin. In this context, post-Keynesians prefer to utilise income policy to control inflation taking into consideration cost-push inflation and the wage-price spiral.

The Nepali economy is at a historical crossroads—passing through a prolonged political transition it currently lacks an investment-friendly environment. Once we look at the disruptions to continuous supply caused by a series of strikes and blockades, low production, the energy crisis and so on, it is not strange to see high inflation in Nepal. Luckily, we haven’t experienced hyperinflation as has been observed in Latin American countries. The highest inflation recorded in Nepal was 21.2 percent in 1991/92 as the economic liberalisation process gained momentum. Given the structure of our economy—low industrialisation and rain-fed agriculture production—containing inflation to less than five percent is hard enough.

How can monetary policy bring down inflation? Following the neo-classical principle, one could argue for increasing interest rates or sucking up liquidity to lower the growth of money supply in the economy. Since last year, interest rates have already risen substantially and pleading for a further

rise in interest rates to combat inflation would be a disaster for the economy. Some productive areas like hydropower construction have already

faced growing production costs due to rising interest rates, with increasing challenges in obtaining credit. It seems this may protract the period of dark-ages in Nepal.

Moreover, sucking up liquidity to tighten the monetary policy will further aggravate the liquidity crunch, which the banking system has been facing for over a year. If the interest rate continues to grow, it may lead to a financial crisis through loan defaults and insolvency. Arguing for a tight monetary policy rests on the false belief that no economic agent ever defaults. As the land prices slide and transactions slow with rising interest rates, borrowers will certainly begin to default on their loan payments, sending a ripple effect across the financial sector.

One cannot deny that an attempt to lower inflation by raising interest rates may itself have an inflationary and redistributive effect. Rising interest rates may promote inflation, especially when firms are highly indebted, by increasing the cost of production. A tight monetary policy will increase the income received by the financial sector at the expense of the indebted sector.

In this situation, monetary policy alone is not enough to curb inflation. But it can be controlled to some extent by ensuring the smooth supply of goods and by strengthening agricultural production, which requires effective law and order and a strong government support system. However, such an effective governance system is not likely in the near future. Since people have a disinterest in agricultural activities, monetary policy does not seem to control impending further inflation, which is going to be emanating from globally rising food prices. Having lower inflation in Nepal will remain an illusion. Any improvements will require a joint effort from all stakeholders.

Shrestha is a PhD student at The New School for Social Research, New York