Makawanpur Multiple Campus

Inflation By Rajan Neupane

Inflation means a substantial and rapid rise in the price level, which causes a decline in the purchasing power of
money. Inflation is statistically measured in terms of a percentage increase in the price index per unit of time.
The phenomenon of inflation can be understood in three ways.

A. Common view

B. Keynesian view

c. Modern view

In common view –Inflation is the phenomenon of rising prices and it is a monetary phenomenon.

In the Keynesian view – It is the phenomenon of full employment. Inflation is the result of excess aggregate
demand over the available aggregate supply and true inflation starts only after full employment. The rise in price
before full employment is semi-inflation.

In the modern view –Two types of inflation can be observed in the modern view. They are demand-pull and cost-
push.

The prices of goods and services do not always remain the same, sometimes it raises and sometimes it falls. The
situation of rising prices of all most all goods and services is termed as inflation. Different scholars of economics
have defined inflation as follows.

According to A. C. Pogou- “Inflation takes place when money income is expanded relatively to the output of
work done by the productive agents for which it is the payment.”

According to G Ackely- “Inflation is a persistent and appreciable rise in the general level or average of prices.”

Thus, inflation is a sustained rise in the general price level of goods and services and it is measured in terms of an
annual percentage increase in the general price level.

Characteristics

1. Regular and continuous rise in the general price level.

2. Cumulative (a small rise in the price in the beginning may take a very large shape in the future)
3. Situation of the increase in general price level (not the increase in individual prices)
4. During inflation the supply of goods and services is less in comparison to their demand.
5. Caused by the monetary factors, it means the prices of goods increase due to the increase in supply of
money.

Types of Inflation
(A) On the basis of rate/speed.
1. A. Creeping inflation: A sustained rise in the price level less than 3 percent per annum is called creeping
inflation which is not very danger to the economy. Such mild level of inflation increases price, income, profit and
so on.
2. B. Walking inflation: A sustained rise in the price level in the range of 3 to 6 percent or less than 10
percent per year is called walking inflation. Such inflation would be dangerous if it is out of control.
3. C. Running inflation: A sustained rise in the price level by more than 10 percent per year is called
running inflation. Such inflation creates several problems in the economy.

4. D. Hyperinflation: Rise in price level by 50 percent or more per annum is called hyperinflation. As the
economy enters in to this situation, people lose their confidence in money. Rather they prefer barter system and
other countries’ currencies.

(B) On the basis of control or government reaction.

A. Open inflation: Inflation is open when there is no barrier to price rise and it exists in the economy in the
absence of government control on the price rise. According to Milton Friedman, open inflation is an “inflationary
process in which prices are permitted to rise without being suppressed by the government price control and
similar techniques.”
B. Suppressed inflation: If the government actively makes effort to check the price rise through a price control
mechanism, is called suppressed inflation.

Demand pull inflation

In demand pull inflation, the general price level rises because of the demand for goods and services available in
current prices. It occurs when aggregate demand is greater than aggregate supply (AD > AS) and price is pulled
upward due to excess demand. The followings are some of the factors which cause the demand pull inflation:
 Increase in money supply.
 Increase in bank credit.
 Increase in private expenditure.
 Increase in export.
 Reduction in taxation.
 Paying off debts.
 Shortage of goods and services.
 Black money.
 Drought, famine or any other natural calamities.
Demand pull inflation can be made clear with the help of the following figure.
In the above figure, quantity of aggregate demand and supply is shown on horizontal axis and price is shown in
vertical axis. Here AD is aggregate demand and AS is aggregate supply. TheAD1curve intersects AS curve at
point A where the equilibrium price is P1 and quantity is Q1. When aggregate demand increases, the initial AD1
curve shifts rightward to AD2 and AD3 which intersects the initial AS curve at points B and C in which the new
equilibrium price level is P2 and P3 respectively. Such increase in price from P1 to P2 and P3 is called semi
inflation. The price increase from P1 to P2 and P3 is due to an increase in aggregate demand for goods and
services at a given supply situation. Corresponding to the P3 level of price, the economy has reached at full
employment level. So the AS curve becomes vertical. If there is further increase in AD to AD4, it increases price
level to P4 where there is no increase in output. Such increase in price level is called pure inflation. So further
increase in AD causes additional rise in price level.

Cost-push inflation.
The cost push inflation is caused by increase in salaries, wages, the rising cost of machinery and capital
equipment and essential raw materials. So it is called supply side inflation. The main causes of cost push inflation
are as follows.
1. Wage push: Wage push is the main determinants of cost push inflation because in any modern times
trade unions have become very strong and they succeed securing higher wages for their members. Due to
increase in wage, the cost of production increases then the selling price rises.
2. Profit push inflation: In monopoly and even in oligopoly market, they able to increase the price of
commodities due to their hold in the market, the profit margin rises and inflation occurs due to the profit
push.
3. Material push inflation: The rise in the price of commodities due to the rise in prices of raw material is
material push inflation.
4. International reason: The economy of one country is related to the economy to other country. Many
countries depend on neighboring and foreign country, for consumer goods and construction materials.
Thus the rise in price of such goods increases the prices in other country too.

Cost Push Inflation can be made clear with the help of following figure.
In the above figure, price level is shown in vertical axis and aggregate demand and aggregate supply is shown in
horizontal axis. In the beginning AD and AS curves intersect each other at point A where equilibrium price is P 1
and quantity is Q1. As a result of shot-supply of goods and services, due to the factors as mentioned above, when
the initial AS curve shifts leftward from AS1 to AS2, new equilibrium is restored at point B with higher price
level P2. If aggregate supply further declines, the AS curve shifts to AS3 thereby given rise to a further increase in
equilibrium price. Thus, such increase in price level from P1 to P2 and further P3 is called cost-push inflation.

Measurement of Inflation

Inflation is measured in percentage term which is simply obtained by calculating the percentage change in current
price index over the previous one. The price indices are developed on the basis of actual survey on market prices
of various goods and services under study. In Nepal, Nepal Rastra bank measures the inflation in monthly basis
comparing to respective month of last year. The commonly used price indices for measuring inflation are:

1. Consumer price index: CPI is often called the retail price index. It measures the average price of goods
and services or it is a statistical estimate constructed using the prices of a sample of representative items
whose prices are collected periodically. The annual percentage change in a CPI is used as a measure of
inflation.
𝐶𝑃𝐼2−𝐶𝑃𝐼1
Inflation in year 2 = ∗ 100%
𝐶𝑃𝐼1
Thus,
 it is the measure of the overall costs of the goods and services purchased by a typical consumer.
 It is designed to reflect changes in the prices of a “market basket” of goods and services purchased by the
consumer.
 It measures changes in the price level of consumer goods and services purchased by the household.
 CPI index is a way of finding the cost of living.
 CPI is computed based on the prices for the “market basket” of necessities including housing, food and
beverage, transportation, entertainment, education, medical care, and other goods and services. Periodic
household survey should be conducted to determine the necessities and consumption pattern of consumer.
2. Producer Price Index: PPI is used to measure the change in the prices received by the producers. So, it
is also called the wholesale price index. This index is used to measure the average prices changes of
goods and services between times at the level of wholesale prices. It is an index of the prices paid by
retail stores for the products they would ultimately resell to consumers. WPI is a measure of changes in
prices charged by manufactures and wholesalers for products. Such prices are monitored before goods
reach retail level and become subject to consumer price index.
3. GDP Deflator: It is also a price index which measures the changes in the overall prices of all newly
produced final goods and services. It is the quantity by which nominal GDP must be divided or deflated
to obtain real GDP. A measure of the price level calculated as the ratio of nominal GDP to real GDP
times 100 is called GDP deflator. The GDP deflator measures the current price level relative to the level
of prices in the base year. GDP deflator is used as an indicator of average prices in the economy. The
percentage change in the value of GDP *deflator is one of the measures of the inflation rate in a country.
 4/GDP deflator=Nominal (current price) GDP/Real (base year price) GDP
Rate of inflation=GDP deflator in year 2 - GDP deflator in year 1 / GDP deflator in year 1*100%

Concept of core inflation

Core inflation is the change in the costs of goods and services but does not include those from the food and
energy sectors. This measure of inflation excludes these items because their prices are much more volatile. So as
inflation is measured by excluding food and energy sector price, it is called core inflation. It is most often
calculated using the consumer price index (CPI) which is a measure of prices for goods and services. Core
inflation is measured by both the CPI and the core personal consumption expenditure index (PCE). The PCE
represents the prices of goods and services purchased by consumers. Since inflation is a measure of the trend in
rising prices, PCE is an important measurement in determining inflation. However, core PCE and CPI are
similar, and both help to determine how much inflation is in the economy.

Key points.

 Core inflation is the change in the costs of goods and services but does not include those from the food
and energy sectors.
 Food and energy prices are exempt from this calculation because their prices can be too volatile or
fluctuate wildly.
 Core inflation is important because it's used to determine the impact of rising prices on consumer
income.

Why Food and Energy Prices Are Excluded

Food and energy prices are excluded from this calculation because their prices can be too volatile or fluctuate
wildly. Food and energy are necessary staples, meaning demand for them doesn't change much even as prices
rise. For example, gas prices may rise with the price of oil, but you will still need to fill up the tank in order to
drive your car. Similarly, you won't be pushing off buying your groceries just because prices are rising at the
store.

Also, oil and gas are commodities and are traded on exchanges where traders can buy and sell them. The price
of food and energy items fluctuate more due to their speculation. This is the cause of high rate of inflation. For
example, a drought can cause dramatic effects on the prices of crops. The effects on inflation remains for short
period, meaning they ultimately correct themselves and the market returns to a balanced state. As a result, food
and energy prices for these goods are excluded from the calculation of core inflation.

Consequences of inflation

Inflation may be desirable so long as it is well under control and increases output and employment. The question
may be what rate of inflation is considered desirable? It may depend on the need of absorption capacity of an
economy which is subject to variation from time to time. The effect of inflation can be divided in to two types.
They are: Economic effect and Non-economic effect.
 A. Economic effect.

1. Effect on production:

Mild inflation is favorable to productivity and employment particularly before full employment. But
hyperinflation disrupts the economy. The adverse effects of inflation on production are stated below.

 Disrupts price system: Inflation disrupts the working of the price mechanism resulting higher price
of the commodities.
 Reduce saving: Inflation adversely affects saving and capital formation. when prices increase, the
purchasing power of money falls, which means the more money is required to meet the previous
living standard. Thus saving declines.
 Discouragement of foreign capital: Inflation not only reduces the domestic saving, it also
discourages the inflow of foreign capital into the country and even drives out the foreign capital from
the country.
 Encourages hording: When there is inflation, holding of large amount of goods will be profitable.
As a consequence of hording, available supply of goods decreases in relation to increasing monetary
demand. This results black marketing and further upward price-spiral.
 Encourages speculation: Inflation promotes speculation activities on account of the uncertainty
created by the continuous rising prices. Instead of earning profit through genuine productive
activities, the businessmen find it easier to make quick profits through speculation.
 Reduces volume of production: Inflation reduces the volume of production because capital
accumulation has slowed down and business uncertainty discourages entrepreneurs from taking
business risk.
 Affects pattern of production: Inflation adversely affects the pattern of production by diverting the
resources from production of essential goods to luxuries because of the demand for such goods by the
inflation benefited group.
 Quality falls: Inflation creates the sellers to command more prices even of the inferior goods as the
people move toward the inferior goods due to the fall in purchasing power of money. Thus the
production of such goods rises in economy.

2. Effects on Distribution.

During inflation the prices of all the factors of production don’t increase in the same proportion. Generally,
the flexible income groups such as businessmen, traders, merchants, speculators gain during inflation due to
windfall profits that arise due to price rise in faster rate than cost of production. On the other hand, fixed
income group, such as, workers, salary earners, teacher, pensioners, interest and rent earners are always the
losers during inflation because their income doesn’t increase as faster as the prices. The effects of inflation on
different group of people are as follows.

 Debtors and creditors: During inflation, the debtors are the gainers and creditors are the losers.
The debtors stand to gain because they have borrowed when the purchasing power of money
would high and in the time return the purchasing power of money becomes low. The creditors, on
the other hand, stand to lose because they gate back less in terms of real value of money.
  Wage and salary earners: These people are losers because wage and salary increases in less
proportion than the proportionate rise in prices and there is time lag between rise in price and rise
in wage and salary. price rise in faster rate than cost of production
 Fixed income group: The fixed income groups are the worst suffers during inflation. People who
live in past saving, pensioners, interest and rent earners suffer most during inflation because their
income is fixed.
 Business community: The business community (traders, producers, entrepreneurs, speculators
etc.) stands to gain during inflation. They earn because price rise in faster rate than cost of
production, price of their inventories go up and normally they are borrowers.
 Investors: The effects of inflation on investors depend on which asset the money is invested. If
the investors invest their money on equities, they are gainers because of the rise in profit. If the
investors invest their money on debentures and fixed income bearing securities, bonds etc, they
are the losers because the income becomes fixed.
 Farmers: Farmers generally gain during inflation because the prices of the farm products increase
faster than the cost of production leading to the higher profits.

Non-economic effects. Social effect, Moral effect, Political effects

Other Effects

Effects on government, Balance of payment, Exchange rate. Collapse of the monetary system:

Measures for Controlling Inflation

Inflation is considered to be a complex situation for an economy. If inflation goes beyond a moderate rate, it can
create disastrous situations for an economy; therefore, is should be under control.

It is not easy to control inflation by using a particular measure or instrument. The main aim of every measure is
to reduce the inflow of cash in the economy or reduce the liquidity in the market.

The different measures used for controlling inflation are explained below.

1. Monetary Measure
Monetary policy refers to the credit control measures adopted by the central bank of a country. Central bank
exercises monetary policy to influence rate of interest, money supply and credit availability. Central bank use
different tools to achieve the objective of controlling the availability of credit in economy and to control inflation.
 Increase in bank rate:
Bank rate is the interest rate at which the central bank lends loan to the commercial banks or it is the minimum
lending rate of the central bank at which it rediscounts first class bills of exchange and government securities
held by the commercial banks. When the central bank finds that inflationary pressures have started emerging
within the economy, it raises the bank rate. Borrowing from the central bank becomes costly and commercial
banks borrow less from it.
 Open Market Operations:
Open market operations refer to sale and purchase of securities in the money market by the central bank. When
prices are rising and there is need to control them, the central bank sells securities. The reserves of commercial
banks are reduced and they are not in a position to lend more to the business community. Further investment is
discouraged and the rise in prices is checked.

 Increase in cash reserves:

The commercial banks have to keep a certain proportion of their total assets in the forms of cash reserve. Some
part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also be kept
with the NRB for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios
are named as CRR and SLR. The Cash Reserve Ratio (CRR) refers to a certain percentage of total deposits the
commercial banks are required to maintain in the form of cash reserve with the central bank. Statutory Liquidity
Ratio (SLR) is the minimum percentage of deposits that a commercial bank has to maintain in the form of liquid
cash, gold or other securities. Central bank increases reserve ratio to control the inflation.
If CRR and SLR are increased, the credit creation power of commercial bank decreases then inflation is
controlled.
 Consumer credit control:
This instrument is used to check the excessive demand and control the price of consumer’s durables. It aims at
regulating the consumer installment credit or hire purchase finance. Hire purchase finance is the method of using
bank credit by the consumer to buy expensive durable goods like motor car, house, computer etc. A certain
percentage of the price of durable goods is paid by the consumers as the down cash payment and the remaining
portion of the price is financed by the bank credit which is repayable by the consumer in installment. The central
bank controls the consumer credit by changing the installment time or cash down payment amount. In inflation
cash down payment amount is increased and the installment time is decreased.
 Credit rationing:
Credit rationing refers to the limit imposed by the central bank upon commercial banks up to which they can get
loans from the central bank. This is how the central bank controls the liquidity of commercial banks in order to
achieve economic goals. This policy by central bank differs in inflation and recession. When there is inflation in
the economy, the central bank extends fewer loans to the commercial banks. This decreases the liquidity of
commercial banks. Whereas, when there is recession in the economy, the central bank extends more loans to the
commercial banks which in return increase the liquidity of commercial banks.
 Margin requirement:
It is the most important instrument of credit control. Commercial banks provide loans to their customer against
some securities. However, they don’t provide the loan equal to the market value of their collateral or securities.
So the difference between the value of the collateral and the amount of loan provided by the commercial bank is
called margin requirements. To control inflation central bank increases the margin requirements.

2. Fiscal measures:
Some of the major instruments of fiscal policy are as follows:
 Budget:
The budget of a nation is a useful instrument to assess the fluctuations in an economy. It is the estimated
statement of the government expenditure and revenue for the coming fiscal year. There are three types of
budgetary policies i.e. balanced budget policy, Surplus budget policy and Deficit budget policy. During the
inflation surplus budgetary policy is adopted and during the phase of depression or deflation deficit or balanced
budgetary policy is adopted.
 Taxation:
Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly affect the
changes in disposable income, consumption and investment. Tax may be direct or indirect. During the deflation
government reduces the tax rate whereas during inflation government increases tax rate.
 Public Expenditure:
The active participation of the government in economic activity has brought public spending to the front line
among the fiscal tools. The appropriate variation in public expenditure can have more direct effect upon the level
of economic activity than even taxes. The increased public spending will have a multiple effect upon income,
output and employment exactly in the same way as increased investment has its effect on them. Similarly, a
reduction in public spending can reduce the level of economic activity through the reverse operation of the
government expenditure multiplier. During inflation government decreases the public spending and during
deflation government increases the public spending.
 Public debt (Borrowing):
Public debt is a sound fiscal weapon to fight against inflation and deflation. It brings about economic stability
and full employment in an economy. Public debt is the debt taken by the government from various sources. There
are two types of borrowing i.e. external borrowing and internal borrowing. Internal borrowing is the borrowing
from private sectors, individuals, bank and financial institutions with in the country and external borrowing are
from the foreign government and foreign financial institutions. During the inflation government borrows from
internal sectors and during the deflation government borrows from external sectors.

The Phillips curve

Trade- off between inflation and unemployment can be known through the study off Phillips Curve. A curve
showing the relationship between the rate of increase in money wage and unemployment rate in the economy is
called Phillips Curves. The curve has been so named after the British economics professor A. W Phillips of
London school of Economics (1958). On the basis of data of the UK for the period between 1861-1957 AD,
Phillips found that there exists a stable, inverse and non-linear relationship between inflation rate and
unemployment rate.

The Phillips curve given by A.W. Phillips shows that there exists an inverse relationship between the rate of
unemployment and the rate of increase in nominal wages. A lower rate of unemployment is associated with
higher wage rate or inflation, and vice versa. In other words, there is a tradeoff between wage inflation and
unemployment. This can be shown by the following figure.
The Phillips curve is shown by PC curve which is convex to the origin and shows the inverse relationship
between the rate of inflation and unemployment. Here, the initial wage rare is W2 and unemployment is U2. If
unemployment falls to U3, wage inflation increases to w3 and if unemployment increases to U1, wage inflation
falls to W1. Similarly, if wage increases unemployment decreases and vice versa.

Deflation

Deflation is opposite of inflation. Deflation is a general decline in prices for goods and services, typically
associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing
power of currency rises over time. According to Crowther,” Deflation is that state of the economy where the
value of money is rising and the prices are falling. “Thus, when the overall price level decreases so that inflation
rate becomes negative, it is called deflation.

A reduction in money supply or credit availability is the reason for deflation in most cases. Reduced investment
spending by government or individuals may also lead to this situation. Deflation leads to a problem of increased
unemployment due to slack in demand.

Causes of deflation

Economists determine the two major causes of deflation in an economy as (1) fall in aggregate demand and (2)
increase in aggregate supply.

1. Fall in aggregate demand

The fall in aggregate demand triggers a decline in the prices of goods and services. Some factors leading to a
decline in aggregate demand are:

 fall in the money supply

A central bank may use a tighter monetary policy by increasing interest rate.Thus, people, instead of spending
their money immediately, prefer to save more of it. In addition, increasing interest rates lead to higher borrowing
costs, which also discourage spending in the economy

 Decline in confidence
Negative events in the economy, such as recession, may also cause a fall in aggregate demand. For example,
during a recession, people can become more pessimistic about the future of the economy. Subsequently, they
prefer to increase their savings and reduce current spending.

2. Increase in aggregate supply

An increase in aggregate supply is another trigger for deflation. Subsequently, producers will face fiercer
competition and be forced to lower prices. The growth in aggregate supply can be caused by the following
factors:

 Lower production costs

A decline in price for key production inputs (e.g., oil) will lower production costs. Producers will be able to
increase production output, which will lead to an oversupply in the economy. If demand remains unchanged,
producers will need to lower their prices on goods to keep people buying them.

 Technological advances

Advances in technology or rapid application of new technologies in production can cause an increase in
aggregate supply. Technological advances will allow producers to lower costs. Thus, the prices of products will
likely go down.

Effects of deflation

Frequently, deflation occurs during recessions. It is considered an adverse economic event and can cause many
negative effects on the economy, including:

 Increase in unemployment

During deflation, the unemployment rate will rise. Since price levels are decreasing, producers tend to cut their
costs by lying off their employees.

 Increase in the real value of debt

Deflation is associated with an increase in interest rates, which will cause an increase in the real value of debt. As
a result, consumers are likely to defer their spending.

 Deflation spiral

This is a situation where decreasing price levels triggers a chain reaction that leads to lower production, lower
wages, decreased demand, and even lower price levels. During a recession, the deflation spiral is a significant
economic challenge because it further worsens the economic situation.

 Reduced Business Revenues

Businesses must significantly reduce the prices of their products in order to stay competitive. Obviously, as
they reduce their prices, their revenues start to drop. Business revenues frequently fall and recover, but
deflationary cycles tend to repeat themselves multiple times.

 Lowered Wages and Layoffs

When revenues begin to drop, businesses need to find means to reduce their expenses to meet objectives. One
way is by reducing wages and cutting jobs. This adversely affects the economy as consumers would now have
less to spend.

Stagflation:

Stagflation is a condition of slow economic growth and relatively high unemployment, or economic stagnation,
accompanied by rising prices, or inflation. It can also be defined as inflation and a decline in gross domestic
product (GDP).

Stagflation was first widely recognized after the mid-20th century, especially in the U.S. economy during the
1970's, which experienced persistently rapid inflation and high unemployment. In the mid-1970s, stagflation was
used to describe the period when the United States faced a prolonged slump and high unemployment along with
rising inflation. It was mainly on the back of OPEC's decision to cut oil supplies. As a result, the oil prices
reached the new heights and hampering productive capacity. The US Fed tried to address the issue by rate cuts
and boosting money supply but output couldn't rise much due to low productivity and oil shortage.

The term "stagflation" was first used during a time of economic stress in the United Kingdom by politician Iain
Macleod in the 1960s while he was speaking in the House of Commons. At the time, he was speaking about
inflation on one side and stagnation on the other, calling it a "stagnation situation." It was later used again to
describe the recessionary period during the 1970s following the oil crisis, when the U.S. underwent a recession
that saw five quarters of negative GDP growth. Inflation doubled in 1973 and hit double digits in 1974;
unemployment hit 9 percent by May 1975.

Thus, Stagflation happens when the economy seems to be raising prices, currency is losing value, and no real
growth is occurring to create jobs. It is a condition in which the price level is rising despite the existence of
substantial unemployment.

Causes of stagflation

 Oil price rise Stagflation is often caused by a supply-side shock. For example, rising commodity prices,
such as oil prices, will cause a rise in business costs (transport more expensive) and short-run aggregate
supply will shift to the left. This causes a higher inflation rate and lower GDP.
 Powerful trade unions. If trade unions have strong bargaining power – they may be able to bargain for
higher wages, even in periods of lower economic growth. Higher wages are a significant cause of
inflation.
 Falling productivity. If an economy experiences falling productivity – workers become more inefficient;
costs will rise and output, fall.
 Rise in structural unemployment. If there is a decline in traditional industries, we may get more
structural unemployment and lower output. Thus we can get higher unemployment – even if inflation is
also increasing.

Nature of Inflation in Nepal

Theories of inflation based on the economic characteristics of developed countries are unable to explain the
nature of inflation in developing countries like Nepal because the characteristics and institutional setup of
developed countries are not similar to developing countries. Developing countries are characterized by internal
factors like highly fragmented market, market imperfection, immobility of factors of production, wage rigidities,
disguised unemployment and underemployment, and sectoral imbalances with a surplus in some factors and
scarcity in others. So, the inflation theories built on the experience and background of the developed countries
have little relevance and can’t be properly applied to developing countries like Nepal.
The following table the CPI-based annual inflation rate of different fiscal years.
Fiscal Year Inflation rate Fiscal Year Inflation rate
2005/06 8 2014/15 7.2
2006/07 5.5 2015/16 9.9
2007/08 6.7 2016/17 4.5
2008/09 12.6 2017/18 4.2
2009/10 9.6 2018/19 4.6
2010/11 9.6 2019/20 6.2
2011/12 8.3 2020/21 3.5
2012/13 9.9 2021/22 5.4
2013/14 9.1

In the fiscal year 2008/09 the inflation rate was 12.6% due to the excessive price rise of food and petroleum
products. After that, the inflation rate had slightly fallen but it was not satisfactory. The inflation rate came down
from the fiscal year 2016/17.
The nature of inflation in Nepal can be listed as follows.
1. The nature of inflation in Nepal is both demand-pull and cost-push.
2. The inflation of Nepal is greatly affected by the inflation of India Due to the fixed exchange rate and high
rate of trade with India.
3. The main causes of demand-pull inflation in Nepal are, increase in consumption expenditure, the inflow
of remittance, increase in government expenditure, deficit financing, expansionary monetary policy,
population growth, scarcity of goods and services, black marketing, high population growth rate, etc.
4. The main causes of cost-push inflation in Nepal are the high price of petroleum products, high price of
raw materials, the high price of imported goods, Monopoly, and cartels in some sectors of the economy.
5. Basically Nepal is experiencing two types of inflation that are walking inflation and running information.

Causes of Inflation in Nepal

The major causes of inflation in Nepal are as follows.

1. Deficit budget
2. Exchange rate
3. Black money
4. Expansion of the private sector
5. Increase in wage
6. Shortage of factors of production
7. Increase in profit margin
8. Natural calamities
9. Influence of the Indian market.

The present scenarios.

 Rising fuel prices: Fuel prices in Nepal and around the world witnessed drastic surges since the outbreak
of COVID-19. Nepal saw the prices of petrol, diesel, and LPG rise by 43%, 57%, and 14%, respectively
since the beginning of 2022. As a result, transportation costs have skyrocketed, subsequently increasing
the cost of industrial production, food products, and other essential items to all-time high.

 Russia-Ukraine war: The effects of the Russia-Ukraine war on the world have also had an impact on
Nepal, adding new challenges to the country’s already struggling economy. Energy, food, and commodity
prices have increased as a direct result of the conflict’s disruption of exports of crude oil, natural gas,
cereals, fertilizer, and metals. The Russian Federation and Ukraine are major exporters of agricultural
products, contributing 25% of the world’s wheat exports, 16% of its corn exports, and 56% of its
sunflower oil exports.
  Depreciation of NPR: With the US dollar trading for NPR 126.05 as of June 30, 2022, the value of the
USD has reached a new historical high in Nepal. The Indian rupee, which the Nepali rupees is pegged to,
has also devalued drastically since the conflict between Russia and Ukraine. For this reason, Nepali
importers, who are already paying high prices for importing goods due to the increasing value of the
USD, would have to pay higher amounts if the dollar keeps appreciating further. Given that Nepal
imports the majority of its necessities, including food, medicine, and fuel – the strengthening of the USD
would not only result in a wider Balance of Payment but would further raise the cost of goods.

 Liquidity crunch: Since the economy in Nepal began to grow after the lockdowns caused by COVID-19
were eased, the liquidity crisis became worse. The commercial banks in Nepal have been facing issues in
keeping the credit-deposit (CD) ratio below 90% due to the delayed deposit collections. Officials from the
NRB claim that the CD ratio at a few banks is still close to 95%. In attempts to attract deposits, banks
have been increasing their interest rates. Increased interest rates translate into higher borrowing costs.
This raises the cost of manufacturing for domestic industries, which in turn drives up the market price of
the goods they supply.

 Fertilizer shortage: Every year, around the time of the rice sowing period, Nepal experiences a scarcity
of urea fertilizers. Over 90% of the farmers, according to the National Federation of Farmers, were unable
to obtain any fertilizer. According to the Ministry of Agriculture and Livestock Development, there are
roughly 600,000 tons of fertilizer needed annually. According to official data from the Government of
Nepal, the cost of fertilizers has increased four to five times in the past year. NPR 15 billion was allocated
by the government for the import of chemical fertilizer. However, the amount would only be enough to
purchase about 200,000 tons, at the present pricing. The harvest for the season could decline further due
to a severe fertilizer deficit during the busiest harvesting period, reducing revenues and heightening
concerns about a food scarcity and rising inflation.

Nominal GDP, Real GDP and GDP Deflator

GDP can be estimated at both current and constant prices. The GDP estimated at current market prices is called
nominal GDP. It is also called GDP at current prices. GDP at current prices does not depict the real economic
status of the country. This is so because when the price level in the country rises, GDP of the country may
increase even though the aggregate output might have decreased. On the other hand, when the price level in the
country falls, GDP of the country may decrease even though the aggregate output might have increased.
Similarly, when the price level in the country changes, GDP of the country can change even without any change
in aggregate output. This means that GDP at current prices (nominal GDP) produces a misleading picture of
performance of the economy when price level is continuously rising or falling. In order to avoid such defect, the
concept of real GDP is used. When GDP of a country is estimated in terms of the prices of a particular year taken
as base, it is called real GDP. In other words, GDP estimated at constant prices that prevailed in a certain chosen
year (known as the base year) is called real GDP. It is also called GDP at constant prices or constant price GDP.
Real GDP is free from the effect of inflation or deflation. Hence, real GDP shows how aggregate production of
goods and services in an economy changes over time. It helps to evaluate the real performance of the economy.

The economists use the adjustment factor called GDP deflator to estimate the real GDP by eliminating the effect
of inflation or deflation on GDP. The GDP deflator measures the current level of prices relative to the level of
prices in the base year. This means that GDP deflator shows the change in GDP due to the change in prices rather
than the change in quantities produced. We can divide nominal GDP by GDP deflator to eliminate the effect of
inflation or deflation on GDP. This means that real GDP can be estimated by dividing nominal GDP by GDP
deflator. GDP deflator can be expressed as follows:
 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator = x 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 x 100

Or, Real GDP = 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟

GDP deflator defined by the ratio of nominal GDP to real GDP is also called implicit GDP deflator. GDP
deflator can be used to measure the rate of inflation over a given period of time. For this purpose, the following
formula is used.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟
Rate of inflation = 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟 x 100

The concepts of nominal GDP, real GDP and GDP deflator can be illustrated through a simple hypothetical
numerical example. Suppose, an imaginary economy produces two final goods X and Y whose quantities
produced and prices in different years are given in the following table.

Year PX (Rs./unit) QX (units) PY (Rs./unit) QY (units)

1990 10 200 15 100
1991 15 300 20 200
1992 20 400 25 300

Year Calculation of Nominal GDP

1990 (10 x 200) + (15 x 100) = Rs. 3500
1991 (15 x 300) + (20 x 200) = Rs. 8500
1992 (20 x 400) + (25 x 300) = Rs. 15500

Year Calculation of Real GDP ( Base year = 1990)

1990 (10 x 200) + (15 x 100) = Rs. 3500
1991 (10 x 300) + (15 x 200) = Rs. 6000
1992 (10 x 400) + (15 x 300) = Rs. 8500

Year Calculation of GDP Deflator

1990 (3500/3500) x 100 = 100
1991 (8500/6000) x 100 = 141.7
1992 (15500/8500) x 100 = 182.4

Year Calculation of Rate of Inflation

1990 –
1991 (141.7 – 100) / 100 x 100 = 41.7% (over the period 1990 – 1991)
1992 (182.4 – 141.7) / 141.7 x 100 = 28.7% (over the period 1991 – 1992)