| Nepal is a small economy which pegs its exchange rate against the currency of its giant neighbor, India. How much has this peg constrained Nepal's monetary policy and whether the peg makes sense are the basic questions which this dissertation address.; Nepal's exchange rate policy is examined in terms of the criteria of the theory of Optimum Currency Areas (OCA). That is, the optimal choice of an exchange rate regime is determined from a cost benefit analysis of certain country characteristics. For example, the criteria of patterns of shocks suggests that regions who face symmetric disturbances may find it less costly to give up monetary autonomy, through a fixed exchange rate, since they would face similar policy prescriptions. The OCA criteria of patterns of shocks is operationalized, through a Vector Auto Regressive analysis, and suggests that the Nepalese and Indian economies do not face symmetric shocks. A cointegration analysis likewise suggests that the Nepalese and Indian monetary base do not share a long term relationship. While these evidences point to a flexible exchange rate as being less costly, the open and contiguous border between both countries, no restrictions on labor and capital mobility and the rigid exchange rate between both countries for almost a forty year period point in the opposite direction. The evidence is thus mixed on what Nepal's exchange rate policy should be.; Nepal's monetary policy is examined through a monetary reaction function which suggests little relationship between the Nepalese and Indian monetary base; this conclusion is consistent with the VAR and cointegration analysis mentioned above. While these evidences point to the Nepalese and Indian monetary policy being independent of each other, this conclusion is hard to reconcile with an open and contiguous border, no capital controls as well as the large size of the Indian economy vis-a-vis the Nepalese economy. Further examination suggests that the agricultural economies of Nepal and India are influenced by the vicissitudes of the weather which add some noise into the analysis of monetary policy. When their respective economic structures are explicitly considered, the conditional Nepalese and Indian monetary base show a long term relationship. This description of monetary policy is consistent with both the policy of the Nepalese monetary authority as well as with onsite discussions at the Nepal Rastra Bank. In other words, this finding may be generalized to say that comparing monetary policy via simple monetary variables may give misleading results. |
