Doctor of Philosophy
School of Business
Exchange rate and monetary policy are emerging topics under consideration in Nepal’s macroeconomic policy discussions. Since the early 1950s, Nepal has fixed the exchange rate with India. Nepal is highly dependent on India for trade and investment and shares an open border. Both the exchange rate regime and level of peg have not been adjusted since 1993, despite several changes in the macroeconomic environment. Existing empirical evidence has demonstrated that Nepal is importing price stability by fixing the exchange rate, real exchange rate has appreciated, external trade competitiveness is weak, and effectiveness of the monetary policy transmission is poor.
Against this backdrop, the thesis explores monetary policy reaction function to understand Nepal's monetary policy and exchange rate interactions; three broad, interrelated objectives are explained in three chapters. The first study tests the uncovered interest rate parity condition's validity between Nepalese rupees and Indian rupees applying a reduced-form new-Keynesian model in the monthly data from 1989 to 2019. The study simulates a state space model based on a maximum likelihood estimation with a Kalman filter approach. The results demonstrate that the uncovered interest rate parity condition does not hold in Nepal, showing a persistent negative risk premium. The study concludes that interest rate and inflation differentials are the primary factors explaining the risk premium. The implication of the risk premium is that holding Nepalese rupees or Nepalese rupee-denominated financial assets provides negative returns for risk-neutral domestic investors, indicating that these are unattractive financial assets.
The second study explores whether the traditional policy trilemma of the Mundell-Fleming model holds in Nepal, with the same reference period of 1989 to 2019 for annual data. The conventional Taylor rule-based monetary policy reaction function is modified by including backward- and forward-looking strategies and embedding the first study's finding on the uncovered interest parity condition. Policy simulation is conducted in a state space model with a Kalman filter. The study found that policy trilemma does not hold in Nepal, where domestic factors have a negligible role in explaining the interest rate. The result implies that Nepal does not maintain monetary policy independence from the trilemma perspective. The primary causes in the absence of policy trilemma can be upsurging remittance inflow and illicit financial flows that do not function to realise official capital flow restrictions.
The third study empirically estimates the same monetary policy reaction function simulated in the second study, with the actual data. The study applies a generalised method of moments model on the quarterly data from 2000 to 2020. The risk premium output of the first study and the monetary policy dependence obtained from the second study are also considered in modifying the standard Taylor rule. The results show that the Taylor-type rule partially holds in Nepal. The real effective exchange rate is the most dominant factor in explaining the interest rate, and inflation expectation has a negative effect.
The study findings provide significant policy implications for policy makers and practitioners in Nepal's monetary policy and exchange rates. Firstly, Nepal’s central bank, Nepal Rastra Bank, should implement a modified Taylor-type monetary policy rule for: enhancing monetary policy communication, signalling market expectations, preventing political interference, and addressing the time inconsistency problem. Secondly, the substantial influence of the real effective exchange rate on the interest rate proves the Dutch disease hypothesis for Nepal, showing that remittance income is accommodated via the real effective exchange rate. The final implication is the feasibility of alternative monetary and exchange rate policies. The choice of an inflation-targeting monetary policy is not feasible in Nepal, based on the earlier finding of Suzuki (2019) and the estimated monetary policy rule of the third study. Domestic inflation expectation does not influence the interest rate in Nepal, such that inflation as an intermediate target is not feasible. This research advises further study of the exchange rate targeting monetary policy.
Bhatta, Guna Raj, Uncovered interest rate parity and monetary policy rule in a small open economy: The case of Nepal, Doctor of Philosophy thesis, School of Business, University of Wollongong, 2022. https://ro.uow.edu.au/theses1/1410
FoR codes (2008)
140212 Macroeconomics (incl. Monetary and Fiscal Theory)
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Unless otherwise indicated, the views expressed in this thesis are those of the author and do not necessarily represent the views of the University of Wollongong.