Inflation and Fiscal Deficit: Examining the Long-Run Relationship in Nepal, 1990–2023

Abstract

This paper examines the long-run relationship between fiscal deficit and inflation in Nepal, asking whether the deficit-inflation nexus that dominates the macroeconomic literature operates in an economy with a fixed peg to a much larger neighbor. The analysis uses annual data from 1990 to 2023 within a five-variable vector error correction framework that includes the consumer price index, the fiscal deficit, broad money supply, India’s consumer price index, and nominal GDP. All five series are integrated of order one, and the Johansen procedure identifies one cointegrating vector. The estimated long-run elasticity of inflation with respect to the fiscal deficit is 0.09, positive and significant but small in economic terms. The Indian CPI elasticity is 0.74, by far the dominant driver of Nepali inflation, while broad money contributes 0.31 and nominal GDP enters with a negative effect of -0.14. An asymmetric specification finds that inflation responds with an elasticity of 0.16 to expansions in the fiscal deficit but only 0.03 to contractions, with a Wald test rejecting symmetry at the five percent level. Sub-period analysis shows that the deficit-inflation elasticity rose from 0.05 in the pre-2010 era to 0.13 in the federalism-era deficit expansion, before stabilizing at 0.11 in the disrupted 2020–2023 window. The error correction term in the inflation equation is -0.31 and significant, indicating moderately fast adjustment. The findings reconcile the standard deficit-inflation framework with Nepal’s peg-driven price formation, showing that fiscal deficits matter quantitatively for inflation but only at the margin and primarily through the monetary transmission channel.