Summary

Economists tell us the exchange rate and inflation are linked. It is more about inflation determining the currency
exchange rate and not vice-versa. However, Nepal's situation is peculiar. Our currency is directly pegged to the
Indian Rupee through a mechanism of a fixed exchange rate which is politics rather than determined by economics.
Therefore, as long as the Indian Rupee does not depreciate, the impact of inflation will not be felt. With the Indian
economy growing at 8%, the chances of Indian rupee depreciating is very slim and therefore we are to a certain
extent
Previous studies have postulated that there exists a positive relationship between the rate of inflation and its variability. They have
shown that a high inflation rate contributes to inflation variability. In this paper, we argue that with the current floating exchange rate
system, exchange rate variability is another factor contributing to inflation variability. After incorporating a measure of exchange rate
variability into a simple model used by previous authors, we estimate our model using cross-country data from 20 developed
and 76 less developed countries. The cross-sectional regression results support our conjecture

The stochastic simulation results suggest that targeting domestic price inflation reduces the

variance in real output, nominal interest rates, the real exchange rate and domestic price
inflation with very little increase in CPI inflation variability. Further, the result appears to be
robust even if direct exchange rate effects influence agents’ expectations of inflation and even
if the monetary authority misperceives the true expectations process.

The empirical results provide strong support for the presence of price stickiness in determining
the degree of passthrough. In particular, both mean inflation and mean exchange rate
depreciation tend to increase pass-through, but in a non-linear fashion, as suggested by the
model. For sufficiently high inflation rates (or mean exchange rate depreciation rates), all prices
are adjusted in every period, and exchange rate pass-through is complete.
In an overall sense, the paper emphasizes the importance of taking account of the
endogeneity of exchange rate pass-through in designing monetary policy for a small open
economy.