Assessment of Nepalese Monetary Policy: A DSGE Model Approach

Abstract

Monetary policy is one of the major policy of a central government of a country. Monetary policy contributes to stabilize the economy in many respects. As such, there is a practice instating suitable monetary policy going back to the time of the great depression. Since then, monetary policy has become one of the intense area to research and study by the economists. Theories like monetarism and New Keynesianism were developed to understand the monetary dynamics and formulate robust monetary policies. Over the past 30 years, New Keynesian theory has been used to understand and formulate new monetary policies with great success. Until recent years, applications of these theories were mostly confined to developed economies. Lately, there have been a substantial number of studies attempting to understand monetary policy using these frameworks in the setting of emerging economies. This thesis is a continuation of that effort in the Nepalese context. Here, I develop a New Keynesian framework to study and identify the features of Nepalese monetary policy using the data for the period of 2002/03 to 2014/15. In particular, I compare three different monetary policy rules to find out which one best represents Nepalese monetary policy, as carried out by Nepal Rastra Bank. I find that Nepalese monetary policy largely resembles Friedman’s k-percent rule, and Taylor rule is an improper model for Nepalese monetary policy. Using this setup, this thesis presents the analysis on the importance of exogenous shocks. The finding of this analysis suggests that Nepalese business cycle is primarily driven by monetary policy shocks and supply shocks. I also find significant level of price rigidity, investment adjustment costs and habit formation in consumption in Nepalese economy. In regards to optimal monetary policy, I find that a policy regime that aggressively targets inflation along with fixed money growth rate maximizes aggregate household welfare, thus is an optimal policy.