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Nepal Macroeconomic Model- Inception Report

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INCEPTION REPORT:
NEPAL MACROECONOMIC MODEL (NMEM) AND
DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM (DSGE) MODEL-
MODEL STRUCTURES, DATA BASE, AND SOFTWARE-HARDWARE REQUIREMENTS

PART-I: MAIN REPORT

DR. TARUN DAS1,2


(FORMERLY, ECONOMIC ADVISER, MINISTRY OF FINANCE, INDIA)

IN ASSOCIATION WITH
PROFESSOR DURGA LAL SHRESTHA3
DR. VIKASH RAJ SATYAL4
MR. ROJAN BAJRACHARYA5

8 OCTOBER 2009

Executing Agency:
The Nepal Rastra Bank,
Baluwater, Kathmandu.

For any clarifications, write to: das.tarun@hotmail.com

1
Macroeconomic Modeling Specialist/ Team Leader (International).
2
Authors would like to express their sincere thanks to Mr. Shahid Parwez, ADB Project/ Program
Implementation Officer and Dr. Nephil Matangi Maskay, Director (Research), Nepal Rastra Bank for
overall guidance, valuable discussions and comments on an earlier draft. However, the Report expresses
personal views of the authors and does not necessarily imply the views of the ADB Nepal Resident
Mission, NRB, MOF and the CBS, Nepal.
3
Macroeconomic Modeling Specialist (National)
4
Econometrician (National)
5
Information Technology Specialist (National)

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Nepal Macroeconomic Model- Inception Report

NEPAL GEOGRAPHIC MAP

Location: 26° 22' N to 30° 27' North, 80° 4'E to 88° 12' East

Political and Administrative Structure


Nepal ( नेपाल ), officially known as the Federal Democratic Republic of Nepal, is a
landlocked country in South Asia and the world's youngest republic. It is divided into five
development regions (Eastern, Central, Western, Mid-Western and Far-Western), and three
ecological regions (Mountain, Hill and Terai). For administrative purpose, it is divided into 75
districts (Zilla) and each district is divided into municipalities and Village Development
Committees that are further divided into wards.

Basic Facts about Nepal:


Fiscal year: 16th July to 15th July of the following year
Items (Year) Units Value Rank in the World
from top
in descending order
Area (2009) Sq. km. 147,181 98 out of 248 countries
Population (2008) Million 29.5 41 out of 241 countries
GDP PPP (2004) Billion US$ 29.3 103 out of 229 countries
GDP Nominal (2006) Billion US$ 8.1 122 out of 229 countries
GDP PPP per capita (2004) US$ 1,352 141 out of 163 countries
GDP per capita (2006) US$ 291 195 out of 207 countries
Poverty Ratio (% of people below Percent 37.7 14 out of 59 countries
One-US$) (2000)
External debt (2006) Billion US $ 3.1 116 out of 196
Debt service ratio (2006) Percentage 4.9 105 out of 128
Source: http://www.nationmaster.com

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Table of Contents

Table of Contents Pages

Contents 3-4
Acronyms and Abbreviations 5
Project Team 6
Acknowledgements 7
Nepal at a Glance by the World Bank 8-9
1. INTRODUCTION- SCOPE, BACKGROUND AND OUTLINE 10-13

1.1 CHARACTERISTICS OF AN IDEAL MACROECONOMIC MODEL 10


1.2 Background of the project 11
1.3 Meeting with ADB Project Implementation Officer, 11
1.4 Meeting with Nepal Rastra Bank 12
1.5 Implementation and Institutional Arrangements 12
1.6 An Outline of the Report 13

2. ECONOMIC CONTEXT OF MODELING 14-17


2.1 GLOBAL FINANCIAL-FOOD-FUEL CRISIS 14
2.2 IMPACT ON NEPAL’S ECONOMIC GROWTH 16

3. RECENT ECONOMIC DEVELOPMENT IN NEPAL 17-23

3.1 ACHIEVEMENT’S OF THE TENTH PLAN (2002/03-2007/08) 17


3.2 THREE YEAR INTERIM PLAN (2007/08 TO 2009/10) 18
3.3 SOCIAL DEVELOPMENT INDICATORS 19
3.4 EXTERNAL DEBT SITUATION 20
3.5 ECONOMIC OUTLOOK, PROBLEMS AND PROSPECTS 20
3.6 DEVELOPMENT CHALLENGES AND ISSUES 21
3.7 STRENGTHS, WEAKNESS, OPPORTUNITIES, THREATS 23
4.0 BUILDING UP AN OPERATIONAL MACROECONOMIC MODEL 24-27

4.1 BASIC PURPOSE AND DIMENSIONS OF THE MODEL 24


4.2 ALTERNATIVE MACROECONOMIC MODELS 25
4.3 INTERNATIONAL BEST PRACTICES AND LESSONS FOR NEPAL 26
4.4 DATA BASE 27

5. BRIEF REVIEW OF PAST MACROECONOMIC MODELLING 28-29


EXERCISES FOR NEPAL

6. ANALYTICAL FRAMEWORK OF A GENERAL MACROECONOMIC MODEL 30-35


FOR NEPAL
6.1 BASIC OBJECTIVES 30
6.2 MODEL STRUCTURE AND ANALYTICAL FRAMEWORK 31
6.3 SPECIFICATION OF THE MODEL AND THE WORK PLAN 35

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7. BRIEF DESCRIPTIONS OF WORKS 36-39


7.1 UPDATING ADB MACROECOMIC MODEL 36
7.2 BUILDNG UP DSGE MODEL 37
7.3 CAPACITY BUILDING AND TRANING 37
7.4 SUPPORT IT GROUP FOR SOFTWARE/HARDWARE SELECTION 37
7.5 PREPARING MANUALS AND ORGANIZING WORKSHOPS 39
7.6 PREPARATION OF THE INCEPTION REPORT 39
7.7 PREPARATION OF QUARTERLY PROGRESS REPORTS 39
7.8 PREPARATION OF TERMINAL REPORT AND ROLL OUT PLAN 39

8. REVIEW AND UPGRADING THE NEPAL MACROECONOMIC MODEL 40-53

9. DEVELOPMENT OF AN OPERATIONAL DYNAMIC STOCHASTIC GENERAL 54-61


EQUILIBRIUM MODEL (DSGE) FOR NEPAL

10. RECOMMENDATION FOR CHOICE OF HARDWARE AND SOFTWARE 62-72


REQUIREMENTS TO RUN THE MODELS

REFERENCES 73-77

PART-II: ANNEXES 1-63

TABLE OF CONTENTS 3

ANNEX-1: COUNTRY ECONOMIC INDICATORS 4

ANNEX-2: COUNTRY POVERTY AND SOCIAL INDICATORS 5

ANNEX-3: SCOPE, CHARACTERISTICS AND TYPES OF MACROECONOMIC 6-20


MODELS
ANNEX-4: DATA BASE REQUIRED FOR TEST AND CALIBRATIONS OF THE 21-25
NMEM AND DSGE-TYPE MODELS FOR NEPAL
ANNEX-5: TERMS OF REFERENCE OF THE CONSULTANTS 26-27

ANNEX-6: BRIEF CV OF THE CONSULTANTS 28-31

ANNEX-7: WORK PLAN MATRIX OF CONSULTANTS 32-36

ANNEX-8A: BROAD FEATURES OF E-VIEWS 6 SOFTWARE 37-56


ANNEX-8B: EVIEWS COMMERCIAL AND GOVERNMENT VOLUME LICENSING 57-62
CONDITIONS AND PRICES
ANNEX-9: LIST OF OFFICERS CONSULTED 63

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Acronyms and Abbreviations

ANA: Annual National Accounts


CBS: Central Bureau of Statistics
CNSP: Consolidated National Statistical Plan
DSGE: Dynamic Stochastic General Equilibrium
EA: Executing Agency
EDPs : External Development Partners
EFA : Education for All
EU : European Union
FAO : Food and Agriculture Organization
FDI : Foreign Direct Investment
FTA : Free Trade Area
FY : Fiscal Year
GDI : Gender Development Index
GDP : Gross Domestic Product
GNP : Gross National Product
HDI : Human Development Index
HDR: Human Development Report/ UNDP
HHs : House Holds
HIPC : Heavily Indebted Poor Countries
HIV : Human Immuno-deficiency Virus
HRD : Human Resource Development
ILO : International Labor Organization
IMF : International Monetary Fund
LDCs : Least Developed Countries
MDGs : Millennium Development Goals
MOF : Ministry of Finance/Nepal
MTEF : Medium Term Expenditure Framework
NGOs : Non-Governmental Organizations
NMEM : Nepal Macro Economic Model
NPC : National Planning Commission/Nepal
NRB : Nepal Rastra Bank
ODA : Official Development Assistance
PPP : Purchasing Power Parity
PRGF : Poverty Reduction and Growth Facility/IMF
PRSP : Poverty Reduction Strategy Paper
Rs. : Rupees/Nepalese
TA – technical assistance
UK : United Kingdom
UN : United Nations
UNDP : United Nation's Development Program
WB : World Bank
WDR : World Development Report/WB
WFP : World Food Program
WHO : World Health Organization
WTO : World Trade Organization

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ADB Project on Macroeconomic Modeling for Nepal

Project Team and Supervisors

Program/ Project Implementation Officer Mr. Shahid Parwez,


ADB Nepal Residence Office

Executive Agency Nepal Rastra Bank

Overall Guidance and Steering Committee, chaired by the


Strategic Direction relevant NPC Member and comprising
representatives of MOF, NRB, and other
relevant line ministries and departments.

Technical Advice and Supervision Technical Committee, chaired by


Mr. Ravindra Prasad Pandey, the
Executive Director of the Research
Department of NRB, and comprising
representatives of MOF, NPC, and other
relevant agencies.

Focal Officer responsible for day-to-day


supervision, coordination and overseeing
the implementation of the TA activities

Project Facilitators

Consultants Prof. Tarun Das, Ph.D., Team Leader and


Macroeconomic Modeling Specialist.

Prof. Durga Lal Shrestha, Ph.D.,


Macroeconomic Modeling Specialist,

Dr. Vikas Raj Satyal, Econometrician

Mr. Rojan Bajracharya, IT Specialist

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Acknowledgements

This Inception Report summarizes the basic objectives and scope of the project and the
major duties, responsibilities, Terms of Reference (TOR) and detailed work plan of the
Consultants viz. the International Macroeconomic Modeling Specialist Dr. Tarun Das,
National Macroeconomic Modeling Specialist Dr. Durga Lal Shrestha, National
Econometrician Dr. Vikash Raj Satyal and National Information Technology (IT)
Specialist Mr. Rojan Bajracharya.

The Report has been produced on the basis of consultations and discussions with the
principal stakeholders and the information and advice provided by them. I express my
sincere gratitude to everyone (a List of officers met is given in Annex-8) who has given
their valuable time for discussions.

First of all, I am grateful to Mr. Shahid Parwez, Program/ Project Implementation


Officer, ADB Nepal Resident Mission for providing all possible support, guidance,
briefing and encouragements at every stage of my works and even before my joining the
Project at Kathmandu.

I would like to thank Mr. Trilochan Pangeni, the then Executive Director, Research
Department for proving valuable backgrounds of the modeling works at the NRB. I
would also like to thank Mr. Ravindra Prasad Pandey, the present Executive Director,
Research Department and the Chairman of the Technical Committee for setting the
motion for modeling works under the project.

I would like to express my sincere gratitude and thanks to Dr. Nephil Matangi Maskay,
Director (Research), Nepal Rastra Bank for overall guidance and valuable discussions
and comments on an earlier draft. I would like to express my thanks to Dr. Bama Dev
Sigdel, Deputy Director and Dr. Ram Sharan Kharel, Assistant Director, Research
Department, NRB, for their enthusiastic cooperation, keen interest, useful discussions and
for providing relevant data and documents.

Finally, I would like to thank my colleagues- the national consultants Prof. Durga Lal
Shrestha, Macroeconomic Modeling Specialist; Dr. Vikash Raj Satyal, Econometrician
and Mr. Rojan Bajracharya, Information Technology (IT) Specialist for providing vital
inputs for preparation of this report.

It is needless to mention that the report expresses my personal views and I am solely
responsible for any errors and omissions.

Kathmandu. Nepal Tarun Das


8th October 2009. Team Leader

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Nepal Macroeconomic Model- Inception Report

Source: Nepal at a Glance, by the World Bank, dated the 24th Sept 2008.

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Nepal Macroeconomic Model- Inception Report

INCEPTION REPORT:
NEPAL MACROECONOMIC MODEL (NMEM) AND
DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM (DSGE) MODEL-
MODEL STRUCTURES, DATA BASE, AND SOFTWARE-HARDWARE REQUIREMENTS

DR. TARUN DAS

IN ASSOCIATION WITH

PROFESSOR DURGA LAL SHRESTHA


DR. VIKASH RAJ SATYAL
MR. ROJAN BAJRACHARYA

1. Introduction- Scope, Background and Outline

“Would you tell me please, which way I ought to go from here?” asked Alice.
“That depends a great deal on where you want to get to.” said the cat.
“I don’t much care where ….” said Alice.
“Then it does not matter which way you go.” said the cat.

--- Extract from Alice in Wonderland, Lewis B. Carrol

Eventually Alice in Wonderland realized that it does matter a great deal to know “where
to go” and “how to get there”. Similarly, in budgeting, planning and monetary
programming, it is important to know the vision, mission and basic goals of an agency;
the scope of its activities in terms of exact inputs, outputs and outcomes in the medium
term, and how to achieve these activities with least resources. Modeling and projections
help to have a clear vision by the planners and facilitate preparation of sound strategic
business and financial plans by a budgetary or monetary agency.

1.1 Characteristics of an Ideal Macroeconomic Model

Desirable characteristics and scope of an ideal macroeconomic model, factors affecting


its formulation, test and calibration; types of various macroeconomic models and their
relative merits and demerits are discussed in details in Annex-3. A model (like a model
for a house or automobile) is an approximation of reality and contains basic features, and
not the exact features of the real object. A macroeconomic model consists of a set of
mathematical, statistical and econometric equations indicating best possible inter-
relationships among major macroeconomic variables. The size and basic building blocks

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of any macroeconomic model depend on various factors such as underlying objectives,


choice of planning horizon, sectoral disagregation and regional disagregation, available
data base, socio-political-global economic context and available resources in terms of
skilled manpower, money and the information and communications technology (ICT).
There are various types of macroeconomic Models (for details see Annex-3) such as
static or dynamic, consistent or optimizing, partial or general equilibrium, sectoral or
economy wide, spatial or regional, inter-temporal or intergenerational, closed or open.

An ideal model should preferably be less complex but comprehensive and dynamic,
internally consistent with unique and stable solutions, and should be easily specified,
identified, estimated, tested and calibrated with the help of reliable data, computer
capacities, simple algorithms and simple statistical/ econometric techniques. A Model
should be continually tested, calibrated, monitored, reviewed, updated, simulated and
improved to make it more realistic over time.

1.2 Background of the Project

The task of the International Macroeconomic Modeling Specialist is to deal with the
Component-B of a wider project called Nepal: Strengthening Capacity for
Macroeconomic Analysis - TA-7165 (NEP), which is being funded by the Asian
Development Bank (ADB). The TA will enhance the Government’s capacity for
economic policy formulation based on reliable macroeconomic data and sound policy
analysis. The TA has two distinct parts viz. (a) to further improve the national statistical
system and (b) to develop and use macroeconomic models for policy simulations,
forecasting and economic planning. While component-A of the TA deals with part (a)
and is being executed by the Central Bureau of Statistics (CBS), Component-B deals with
part (b) and is being executed by the Nepal Rastra Bank (NRB).

Modeling Team comprises Prof. Tarun Das, Macroeconomic Modeling Specialist/ Team
Leader; Prof Durga Lal Shrestha, Macroeconomic Modeling Specialist; Dr. Vikas Lal
Satyal, Econometrician and Mr. Rojan Bajracharya, IT Specialist. The basic task of the
Modeling Group is to review and upgrade the Nepal Macroeconomic Model (NMEM)
built by ADB in 2005 and to build an alternative Model in the framework of a Dynamic
Stochastic General Equilibrium (DSGE) Model. The respective Terms of References
(TOR) of the consultants are reproduced in Annex-5, the respective brief CVs of the
consultants are given in Annex-6.1 to Annes-6.4 and the respective Work Plan Matrices
are given in Annex-7.1 to Annes-7.4.

1.3 Meeting with Project Implementation Officer

Prof. Tarun Das arrived Kathmandu on Sunday, the 23 rd August 2009 and reported to Mr.
Shahid Parwez, Program/ Project Implementation Officer, ADB Mission Resident Office
at Srikunj, Kamaladi, Kathmandu on the morning of Monday, the 24th August 2009. Mr.
Parwez briefed on the overall scope and basic objectives of the project, and explained
detailed Terms of Reference (TOR). Mr. Parwez emphasized that the job of an
International Macroeconomic Modeling Specialist envisaged under the TOR is very

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challenging as he is expected to have high technical capability to deal with complex


econometric models, provide advice on selection of desired software and hardware,
prepare manuals on test, calibration, algorithms and projections; and provide hands-on
training to the officers engaged in modeling. He further advised that an Inception Report
is required to be produced within one month followed by quarterly and half yearly
progress reports on the modeling works. All tasks under the Terms of Reference have to
be delivered in a time-bound manner as and when required by the authorities.

Mr. Das assured Mr. Parwez that he fully understands the challenging tasks and
responsibilities of the International Macroeconomic Modeling Specialist and would
provide his best efforts and knowledge to come up to the expectations of the authorities.
However, he expects full cooperation of other members of the Modeling Group and all
possible help by the Executing Agency to provide required infrastructure support, and
relevant data and information in time.

1.4 Meeting with Nepal Rastra Bank

In the afternoon of Monday, the 24th August 2009, Mr. Parwez organized a meeting with
Dr. Nephil Matangi Maskay, Director (Research), Nepal Rastra Bank, where local
consultants and the modeling facilitators Dr. Bama Dev Sigdel, Deputy Director and Dr.
Ram Sharan Kharel, Assistant Director, Research Department, NRB, were also present.
Details of the works plan and the role of the NRB as the EA were discussed. The NRB
was requested to set up a Technical Committee and to develop contacts with the Steering
Committee as early as possible. In consultation with Dr. Maskay, the Team Leader has
prepared a Work Plan which is reproduced in Annex-7.1.

Next day (Tuesday the 25th August, 2009) International Consultant had an opportunity to
meet the then Executive Director Mr. Trilochan Pangeni who provided valuable insights
on the modeling works at the NRB. Subsequently, on Wednesday, 2nd September 2009
the International Consultant met the present Executive Director Mr. Ravindra Prasad
Pandey, who is also the Chairman of the Technical Committee.

1.5 Implementation and Institutional Arrangements

CBS is the Executing Agency (EA) for component A of the TA and NRB for component
B. Both components of the TA will be implemented in close coordination with other
relevant Government agencies, including MOF, NPC, and other line ministries and
departments. Until a Focal Officer is decided by the Technical Committee, Dr. Nephil
Matangi Maskay, Director (Research Department), Nepal Rastra Bank, has been kind
enough to take the responsibility for overall supervision and coordination, and to oversee
the day-to-day implementation of the TA activities on modeling, to maintain close
coordination with all relevant stakeholders, and to manage the consultants’ inputs.

For both the components, a Steering Committee will be formed—chaired by the relevant
NPC Member and comprising representatives of MOF, NRB, CBS, and other relevant
line ministries—to provide overall policy guidance for implementation of the TA,

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monitor progress, and take necessary actions to facilitate implementation of the TA. In
addition, two Technical Committees (TCs) will be formed to provide technical advice
and guidance on the respective TA activities. For component-B on Modeling works, TC
will be chaired by the Executive Director (Research), NRB and comprise representatives
of MOF, NPC, and other agencies. The technical committee will also coordinate with
other macroeconomic modeling activities; including the proposed UNDP supported
macroeconomic modeling for monitoring the MDGs.

1.6 An Outline of the Report

With this brief introduction on modeling and project background, the rest of the report
has 9 additional sections and 9 Annexes. Section-2 deals with both global and domestic
economic context of modeling. Section-3 makes a critical appraisal of the current state of
the Nepalese economy, its development challenges, problems and prospects, and its
inherent strengths, weakness, opportunities and threats (SWOT analysis). Section-4
makes a critical review of the macroeconomic modeling works for Nepal. Section-5
describes alternative macroeconomic models and building blocks for an operational
macroeconomic model for Nepal. Section-6 describes an analytical framework of a
general equilibrium model for Nepal. Section-7 deals with specific work plans and brief
descriptions of the activities of the consultants during the project period.

Section-8 makes a critical review of the Nepal Macroeconomic Model (NMEM)


developed by the ADB in 2005 and provides the upgraded structure of the NMEM, which
will be calibrated and tested by the consultants. Section-9 provides a tentative structure
for an operational Dynamic Stochastic General Equilibrium (DSGE) Model for Nepal,
which will be fully developed, tested and calibrated by the consultants with available data
and computer algorithms. Section-10 recommends hardware and software requirements
for estimation, test, calibration, projection and simulations of the models.

The report is then followed by selected references and nine Annexes. Annex-1 and
Annex-2 present trends of major macroeconomic variables and poverty and other social
indicators for Nepal. Annex-3 makes a critical review of basic characteristics, types and
technical structures of various macroeconomic models. Annex-4 provides the complete
list of variables and data requirements for the specification, test and calibration of the
upgraded Macroeconomic Model and the Dynamic Stochastic General Equilibrium type
of model for Nepal. Annex-5 reproduces the respective Terms of Reference (TOR) of the
consultants as specified under the ADB Project (TA-7165-NEP) on Nepal: Strengthening
Capacity for Macroeconomic Analysis. Annex-6 provides brief curriculum vitae of the
consultants, while Annex-7 provides the respective Work Plan Matrices of the
Consultants.

Annex-8 presents the broad features, licensing conditions or commercial and government
volume contracts for the E-Views 6 Software which is recommended by the modeling
team for estimation, test, calibration, forecasting and simulation the Nepal
macroeconomic models. Annex-9 provides a list of officers who were consulted to
prepare this report.

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2. Economic Context of Modeling

Before reviewing modeling structures, it may be useful to provide a brief account of the
global economic situation and the current state of the Nepalese economy.

2.1 Global Financial-Food-Fuel Crisis and Economic Slowdown

It is well known that the global economy is presently passing through a critical
conjecture. It was adversely affected by three worst crises in fuel, food and financial
sectors (called F-3 Crisis) in a single year in 2008 - the first massive F-3 crisis in the last
70 years since the great depression in 1930s. Both the advanced and developing countries
have adopted various monetary and fiscal stimulus packages (such as cuts in central bank
policy interest rates, continued provision of bank liquidity, credit easing, provision of
public guarantees, bail outs and bank recapitalization etc.) to boost both investment and
consumption, output and employment. In their latest World Economic Outlook (WEO)6
of October 2009, the International Monetary Fund (IMF) concludes that although the
global economy has started to pull out of the unprecedented recession, recovery is
expected to be weak and slow, and jobless for sometime, as financial systems remain
impaired, support from public policies will gradually have to be withdrawn, and
households that suffered asset price busts will continue to rebuild savings.

As per the IMF projections made in the WEO October 2009, global growth is expected
to reach about 3 percent in 2010, following a contraction in activity of about 1 percent in
2009 (Table 2.1). During 2010–14, global growth is expected to be just above 4 percent,
appreciably less than the 5 percent growth rates in the years just ahead of the crisis.
Achieving this turnaround will depend on stepping up efforts by the governments of both
developed and developing countries to heal the financial sector, while continuing to
support demand with monetary and fiscal easing.

In recent years Asian economies in general experienced an economic boom contributed


by two favorable factors: namely (a) rising exports driven by high commodity prices,
and (b) increasing inflows of remittances and foreign investment. The ongoing financial
crisis and economic slowdown in the developed countries have led to reversal of these
positive factors and imposed serious adverse impact on the Asian economies.

Growth projections in emerging Asia have been revised upward to 6.2 percent in 2009
and 7.3 percent in 2010. The upgrade owes to improved prospects in China and India, in
part reflecting substantial macroeconomic stimulus; and a faster-than-expected
turnaround in capital flows. However, the recent acceleration in growth is likely to peter
out unless there is a recovery in advanced economies.

Growth is expected to moderate particularly in commodity exporting countries, and


many countries are experiencing declining exports and lower inflows of tourism income,
remittances, and foreign direct investment (FDI), while aid flows are under threat.

6
World Economic Outlook- Sustaining the Recovery, October 2009, IMF Washington D.C.

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Table-2.1 IMF WEO (Oct 2009) Projections (Annual Growth Rate in Percentage)

Source: World Economic Outlook- Sustaining the recovery, October 2009, International Monetary
Fund, Washington D.C.

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2.2 Impact of Global Economic Crisis on Nepal’s Economic Growth

A crisis of this magnitude in the industrialized countries is bound to have an adverse


impact around the world. Nepalese economy may not be an exception to it. Nepal is a
low-income and land-locked country. With an area of 147,181 km² (98th in the world) and
population of 29.5 million (41st as per 2007 UN estimate), Nepal had a per capita income
of only US$291 (195th among 207 countries) in 2007 and low domestic purchasing
power. So its growth depends on external demand and growth in the neighboring
countries and other trading partners. Nepal has always maintained a relatively open
economy for trade and investment, although exchange rate is pegged to Indian rupee.

As is evidenced by table 2.2, exports of goods and services and external transfers
(particularly grants and workers’ remittances) have significant contributions to GDP. The
table further indicates that the external flows were not adversely affected by the global
financial crisis and the economic slowdown.

Nepal’s total trade (exports plus imports) of goods and services as percentage of GDP
increased from 45 percent in 2007 to 46 percent in 2008 and further to 48 percent in
2009. Gross flows on current account (i.e. total inflows plus outflows on goods, services,
income and transfers) as percentage of GDP increased from 66 percent in 2007 to 71
percent in 2008 and further to 78 percent in 2009. Similarly, gross flows (inflows plus
outflows) on both current, and capital and financial account as percentage of GDP
increased from 70 percent in 2007 to 76 percent in 2008 and 85 percent in 2009.

The Nepalese economy was least affected by the initial adverse effects of global financial
crisis. The reasons include the following:

(a) Nepal’s financial sector has limited external liabilities and assets.
(b) Although its external current account has close links with the rest of the world,
the major link is with India which maintained relatively high growth rates during
the crisis period.
(c) Nepal and India also maintained normal trade links.

Table-2.2: Nepal: Measures of globalization


(As % of GDP at current market prices)
Items 2007 2008 2009
1. Exports of goods & services 13 13 13
2. Imports of goods & services 32 33 36
3. Gross Trade (Exports plus imports)=1+2 45 46 48
4. Gross Income (Inflows + outflows) 3 2 2
5. Gross transfer (Inflows + outflows) 19 23 28
6. Gross Current Account = 3 + 4 + 5 66 71 78
7. Gross Capital and financial flows 3 5 7
8. Gross current + Capital flows = 6 + 7 70 76 85
Source: Estimated on the basis of primary data obtained from the Nepal Rastra Bank.

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Economic Growth

(a) Although the initial global financial crisis did not have much adverse impact on
the Nepal’s financial sector, the real sector growth in 2008/09 has been affected
adversely due to domestic factors such as unfavorable monsoon and labor unrest.
Based on the data available for the first six months of the fiscal year 2009, the Central
Bureau of Statistics (CBS) has estimated the real GDP growth rate at basic prices is
expected to decelerate from 5.3% in FY2008 to 3.8% in FY2009. The slowdown is
expected to be broad-based, encompassing agriculture, industry and services. The
agriculture sector is expected to grow by only 2.2% in FY2009, down from 4.7% in
FY2008; industrial sector by 1.8% almost the same as 1.9% in FY2008; and service
sector by 5.8%, significantly down from 7.0% in FY2008.

(b) There is acceleration of the consumer price inflation which is presently running
around 13 percent due to high food prices. The stock market is bearish in general.
However, the fiscal situation and the balance of payments have surplus on current
accounts and macroeconomic fundamentals are sound. Both the government and the
monetary authority deserve to be complemented for maintaining economic stability in
a difficult socio-economic-political context.

3. Recent Economic Development in Nepal


3.1 Tenth Plan Period

In recent years Nepal made significant progress toward sustainable economic growth and
is committed to the so-called LPG (viz. liberalization, privatization and globalization).
Government priorities over the years focused on the integrated development of
agriculture, industry, transportation and communications. Agriculture remains Nepal's
principal economic activity, employing 70% of the wok force and contributing 33% to
GDP. Rice and wheat are the main food crops. Out of total land, only 20% is cultivable;
another 33% is forested; and the rest is mountainous.

The performance of the Tenth Plan was mixed. Significant progress was made in the
areas of MDG indicators including poverty reduction, but the achievement on economic
growth was below expectations.

The Tenth Plan had targeted normal economic growth rate to be an annual 4.3 percent on
an average (agricultural sector 2.8 and nonagricultural sector 5.2). However, during the
Plan period the average annual growth rate remained 3.4 percent (agriculture sector 2.67
percent and the non-agriculture sector 3.79 percent). Some structural changes in the
economy were observed. Over the period, the contribution of agricultural sector in GDP
declined from 37.4 percent to 33.1 percent, while that of non-agricultural sector increased
from 62.6 percent to 66.9 percent. Among the non-agriculture sector, trade and
commerce, hotel and restaurant performed better,

During the plan period, the total consumption, on an average, remained 89.84 percent.
The gross capital formation remained 25.57 percent of the Gross Domestic Product.

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Nepal Macroeconomic Model- Inception Report

Similarly, the Gross Domestic Savings remained an annual average of 10 percent and
Gross National Saving 28.1 percent of the Gross Domestic Product. Although no change
was seen during the Tenth Plan period in the Domestic Saving and Consumption, a
positive change in Gross Capital Formation and Gross National Savings was observed.
During the plan period there was some deterioration in the current account surplus, whereas
an improvement has been observed in the balance of payments position

Despite sound macroeconomic management by the government, foreign investors stayed


away from Nepal due to political uncertainty and difficult business environment. Fiscal
management, in general, was under control. Revenue increase, together with a declining
trend of development expenditures in real terms helped to keep fiscal deficit within
sustainable limits. However, resource gap, measured by the saving-investment
differences, increased from 11% of GDP in 2002 to 18% of GDP in 2006. On the
contrary, Gross National Savings (GNS) increased significantly mainly because of
increasing remittances inflows.

The average annual inflation measured by the national consumer price index, was
contained at the average rate 5.5% during the Tenth Plan with a peak of 8% reached in
2005/06 mainly because of rise in petroleum product prices. Transport, communications
and housing recorded the highest price rises during the Plan period.

During the Tenth Plan, despite deceleration of the exports growth and rising trade deficit,
the current account and overall balance of payments position remained strong due to
increasing inflows of remittances.

3.2 Three Year Interim Plan (2007/08 to 2009/2010)

As the Tenth Plan came to an end in July 2007, after the culmination of a series of
historical struggles in the form of the 2006 People's Movement, the National Planning
Commission (NPC) prepared a three year Interim Plan from FY 2007/08, consistent with
the people’s aspirations, the Interim Constitution, and the Common Minimum Program of
the government. For the first time in the country's history of plan formulation, the NPC
targeted to more than 70 VDCs of 30 districts, carrying out direct observation and
collecting people's suggestions. Similarly, at the central level, consultations were held
with all stakeholders.

The main objective of the Interim Plan is to realize changes in the life of people by
reducing poverty and unemployment and establishing sustainable peace. It puts special
emphasis on increasing public expenditure for employment generation, peace building,
reconstruction, rehabilitation, reintegration, inclusion, and revitalization of the economy.
Similarly, the Plan provides special attention to women, the poor, weaker sections of the
society and development of remote areas.

The strategies of the Plan include the following:

• To give special emphasis to relief, reconstruction and reintegration:


• Creation and expansion of employment opportunities.

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• To increase pro-poor and broad-based economic growth,


• Promotion of good-governance and effective service delivery:
• Increase investment in physical infrastructures:
• Adopt an inclusive development process.
• Clear policies, institutional structures and programs, and
• Carry out targeted programs.

The following table summarizes the quantitative targets of the three year Interim Plan.

3.3 Social Development Indicators and MDGs

Despite politically difficult situation, trends of many poverty and socio-economic


indicators in the 10th Plan period were encouraging (Annex-2). The incidence of poverty
fell from 42% in 1996 to 31% in 2004. Similarly, the Demographic Health Survey (2007)
shows that net enrollment in primary school rose from 80.4% in the beginning of the Plan
to 87.4% in 2007. Maternal mortality rate, child mortality rate and infant mortality rate
declined, significantly during the Plan period.

However, a joint study by the National Planning Commission of Nepal and the UNDP
Country Team in Nepal indicates that Nepal remains off-track as regards the MDG
targets on universal primary education and incidence of HIV/ AIDS, malaria and other
diseases (NPC/ UNDP 2005).

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3.4 External Debt Situation

As the country's investment requirements far exceed the internal savings, access to
external capital, in the form of loans or grants, is inevitable. However, Nepal has
managed external debt very well. The external debt to GNI declined from 52 per cent in
FY2000 to 38 per cent in FY2006, and external debt service (to exports of goods and
services ratio) declined from 9.7 per cent to 5.1 per cent over the same period. Nepal's
external debt stock is composed of high levels of concessional loans with long maturities
and nominal interest charges. The share of short-term debt in total debt is negligible,
although in recent years it has shown an upward trend. The country has foreign exchange
reserves, equivalent to about 7.5 months imports cover.

Table-3.1 External Debt Situation in Nepal (US$ Million)


Items 2000 2001 2002 2003 2004 2005 2006
Ext.Debt outstanding 2869 2735 2992 3164 3358 3198 3409
Long-term Debt 2827 2673 2948 3139 3300 3130 3285
Short-term Debt 29 54 40 13 36 47 81
Use of IMF credit 12 8 4 11 22 20 43
Sustainability Indicators
Ext.Debt as % of GNI 52 45 50 50 46 39 38
Short term/ Total Debt (%) 1.0 2.0 1.3 0.4 1.1 1.5 2.4
Debt service/ XGS ratio (%) 9.7 7.0 6.3 6.1 5.6 4.7 5.1
Interest (percent per annum) 1.4 1.3 1.2 1.0 1.0 1.1 1.3
Maturity (years) 31.4 30.5 33.7 34.9 36.8 34.6 24.6
Grace period (years) 8.1 8.2 9.8 9.3 9.5 8.7 8.1
Grant element (percent) 69.5 69.5 73.3 75.1 76.8 74 66
Note: Years refer to fiscal year.

3.5 Economic Outlook, Problems and Prospects

The Central Bureau of Statistics (CBS) of Nepal has estimated that the Real Gross
Domestic Product (GDP) would grow by 3.8% in 2008-2009, compared to 5.3 percent
recorded in 2007-2008. However, as per the assessment made by the ADB7, the growth
rate is likely to be lower due to poor winter crop, deceleration in remittances inflow and
slower industrial growth caused by continued power shortage and long-term structural
weaknesses in the economy. The deceleration of the growth rate is also partly due to the
global economic slowdown as discussed earlier.

Overall annual point-to-point consumer price inflation at the end of ten months of 2008-
2009 stood at 12.9% driven by high food prices and higher salaries and wages. With poor
winter crop output, it is unlikely that inflation will moderate significantly for the rest of
the year. In general, it was observed in the past that there exists a high positive
correlation between inflation rates in India and Nepal. However, in the recent months,
Nepalese inflation has not followed the decelerating trends of the Indian overall inflation,
due to high food prices in both India and Nepal.
7
Quarterly Economic Update- Nepal, Vol.VI, No.1, June 2009, ADB.

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Money supply is expanding at a lower rate than last year, and the momentum in liquidity
expansion has been curtailed by large share subscriptions of commercial banks. But,
given a fixed exchange rate with Indian Rupee since 1991 and high international prices of
major imports of Nepal (viz. food items and petroleum products), Nepal Rastra Bank
(NRB) has a difficult task of controlling inflation without impeding much-needed
investment for sustaining economic growth.

Tax reforms introduced in the past have led to an improvement in revenue mobilization
and a healthy fiscal position, although it is partly due to low capital spending.

In the external sector, both the current account and the overall balance-of-payment
positions remain in surplus, although inflows of foreign investment have been adversely
affected to some extent by political environment. Within the current account, trade deficit
continues to widen, but it is more than offset by remittances inflow and tourism receipts.
It is expected that external balance will remain favorable due to continued inflows of
remittances by Nepalese citizens working abroad.

Nepal’s commercial banks hold insignificant foreign liabilities. Consequently, the first-
round effects of the global downturn were not observed in Nepal, although the Nepalese
rupee depreciated against third currencies due to its peg to the Indian rupee. The outlook
of other channels such as trade and remittances is also optimistic, although tourist arrivals
have declined in recent months.

3.6 Development Challenges and Issues

During the last five years the Nepalese economy had performed reasonably well with
moderate and stable economic growth, increasing per capita income, buoyant investment,
moderate inflation, low fiscal deficit and favorable balance of payments situation. But,
these favorable trends have not led to commensurate reduction of poverty in rural and
hilly areas. This implies that the so-called trickle down effects of growth had been
delayed, slow and uneven. The worldwide recent financial crisis and economic slowdown
along with domestic political transition might have further exacerbated the economic
situation in Nepal.

These trends have led to various development challenges such as how to sustain
economic growth with fiscal prudence, monetary discipline and price stability, how to
promote equitable growth and to raise the levels of living of all citizens, how to eradicate
poverty, hunger and disease and to attain other Millennium Development Goals (MDGs)
at a faster speed, and how to create enabling environment for public-private partnership
and international cooperation in the development process for improving quality and
delivery of basic public goods and services.

Another important development challenge is how to use government revenues for


attaining higher growth and at the same time tackling the problems of poverty and
inequity. Although the concerned ministries have the major responsibilities for achieving

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Nepal Macroeconomic Model- Inception Report

MDG targets, the Ministry of Finance and the National Planning Commission, being the
coordinating Agencies, have special responsibilities to provide necessary advice and
directions to other ministries.

The core challenge for the government budget is how to adopt long-term MDG targets
within the annual and medium-term national budget constraints and priorities. MDG
strategies are both ‘needs based’ and ‘resource constrained’. The national budget must
take care of poverty reduction strategies as a guide to MDG action, and set out clear
priorities for pro-poor public expenditure and investment plans based on a realistic
assessment of the available resources and the needs of other sectors.

The country’s economic growth has remained low and needs to be reinvigorated by
increasing agriculture production and productivity and improving environment for private
investments including foreign investment. There is also need to improve institutional set
up and governance, liberalize labor laws, and improve investment climate and physical
infrastructure. Nepal’s road density is one of the lowest even among the least developed
countries. Similarly the country suffers from severe electricity shortage.

Population pressure on natural resources is increasing. Over-population is already


straining the "carrying capacity" of the middle hill areas, particularly the Kathmandu
Valley, resulting in the depletion of forest cover for crops, fuel, and fodder and
contributing to erosion and flooding and other environmental hazards.

The challenge is not only of accelerating growth, but also of sharing the growth and
prosperity more broadly across the population. Building social and human capital,
creating employment opportunities and implementing affirmative actions to the excluded
groups are probably the best ways for reducing poverty and inequality in the country. If
all Nepalese people are healthy, educated, skilled and live longer, they can participate
fully, contribute more and gain from the development process..

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3.7 SWOT Analysis for the Nepalese Economy

On the basis of above discussion, a SWOT analysis of the Nepalese economy is presented
in the following table.

Table-3.2 SWOT Analysis of the Nepalese Macro-economy

1. Sustainable moderate economic growth in recent years


2. Good performance by services sectors.
Strengths 3. Rising trend of tax/ GDP ratio;
4. Manageable fiscal deficit, with surplus in overall fiscal balance
in 2008/09.
5. Rising trend of gross domestic investment ratio
6. Rising trend of national savings ratio
7. Good performance of major social development indicators
Internal environment

including reduction of poverty


8. Country is on track on most of the MDG targets
1. Growth rate remains vulnerable to weather shocks;
2. Low productivity of agriculture;
Weaknesses 3. Industrial sector remains week due to political uncertainty,
labor unrest, and constraints on electricity supply and other
infrastructure facilities;
4. Inflation pressures in 2009
5. Low levels of domestic savings
6. Large proportion of current expenditure and low levels of
investment in public expenditure
7. Although overall poverty ratio is declining, poverty incidence
remains high in rural and hilly areas
8. Degradation of environment in cities
Opportunities 1. Located between two giant economies and fast growing
neighbors (China and India) with positive pulls and pushes on
the Nepalese economy
2. Surplus in the external current account during 2004-2009
except for marginal deficit in 2007
External environment

3. Comfortable foreign exchange reserves (equivalent to 7.5


months of imports during 2006-2009)
4. Declining ratios of external debt to GDP ratio
5. Very low external debt service ratios indicating sustainability
of external debt over time (and possibility of no debt trap)
Threats  Overall economic growth and government revenue remain
vulnerable to terms of trade shocks trigged by possible sharp
declines in international prices of Nepalese exports
 Deceleration of remittances growth in 2009
 Balance of payments remains vulnerable to future risk of
hardening of global oil prices

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4. Building up an Operational Macroeconomic Model for Nepal

A comprehensive Macroeconomic Model can specify, test and calibrate complex and
dynamic interrelationships among major economic variables with the help of powerful
analytical, statistical and econometric tools that can be very useful for forecasting and
policy planning by the Ministry of Finance, National Planning Commission, Nepal Rastra
Bank and other departments and stakeholders both within and outside the government.

A macroeconomic model can analyze trends of both the internal and external variables in
a consistent analytical framework, and address various important issues such as
controlling inflation, tackling balance of payments problems, sustaining growth in the
medium to long term, examining inflation-growth-poverty-inequality trade-offs,
managing public debt and fiscal deficit at sustainable levels, and determining permissible
levels of monetized fiscal deficit. As observed by Clements and Hendry (1995): “ Formal
econometric systems of national economies fulfill many useful roles others than just
being devices for generating forecasts. For example, such models consolidate existing
empirical and theoretical knowledge of how economies function, provide a framework
for a progressive research strategy, and help explain their own failures”.

4.1 Basic Purpose and Dimensions of a Macroeconomic Model

The basic purpose of the model is to make the projections of the following variables for
the medium term 2009/10-2013/14:

• Sectoral GDP and overall GDP


• Distribution of GDP among private and government consumptions, savings,
investment, exports and imports
• Consumer price and overall price inflation, interest and exchange rates,
• Government fiscal operations, overall fiscal balance and public debt,
• Major items in the balance of payments, and
• Major monetary and financial statistics.

Existing economic system is complex and has close linkages with the socio-political-
external environment. Naturally a modeller needs to make certain presumptions about
these initial conditions and to build alternative scenario for future. So, a number of
questions need to be answered before an operational model can be developed:

 How can we understand such a complex system?


 Are our preconceptions correct?
 Do we have a reliable data base for the past 25 years?
 Do the available data tell us what we desire to know?
 How complicated or simple the Models should be?
 Can the alternative Scenarios built by modellers address the questions raised by
policy makers and other stakeholders?

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These questions are simple, but there are no simple and general answers. A modeller has
to make a compromise between what is theoretically and technically justified and what
kinds of data are produced by the CBS, NPC, MOF, NRB and other agencies.

Preconceptions: Economic development is a historical process which depends on:


 Existing socio-political-legal-institutional context
 Financial, capital and money markets
 Labour markets, labour laws and industrial technology
 State of infrastructure, information and communications technology (ICT)
 Public policies and available resources
 Global economic environment and prospects

Can we capture the historical process with past trends of statistical data? The answer is-
yes and no. If the past statistical data are incomplete and imperfect, future cannot be
predicted on the basis of it. Fortunately, for modellers, over the years Nepal has built up
authentic and comprehensive data bank on all sectors of the economy and these are easily
available on the websites of the MOF (www.mof.gov.np/), CBS (www.cbs.gov.np/) and
the NRB (www.nrb.org.np/ ).

The best set of data available for the Nepalese economy includes the following:

 Government Financial Statistics produced by the MOF


 National accounts, real sectors and prices statistics produced by the CBS
 Balance of payments and exchange rate data produced by the NRB
 Monetary and Financial Statistics produced by the NRB

A modeller also faces the following questions while specifying models.


• How much detailed a model should be?
• What are the structural relationships and the reduced form relations?
• Are these relevant to the questions we want to answer?
• Are these consistent with what we know about institutions?
• Are these consistent with results of past studies?
• Are these dynamic enough to capture in changes in food and oil prices?
• How much regularity and time gap should be there for updating a model?

4.2 Alternative Macroeconomic Models

Depending on the purpose and availability of data and resources, alternative


macroeconomic models as indicated below can be explored:

(i) Consistency Model in the Leontief Input-Output (I-O) Framework


(ii) Social Accounting Matrix (SAM) and General Equilibrium Model
(iii) Linear Programming (LP) Model and Gravity Model
(iv) Structural Macroeconometric Model
(v) Vector Autoregressive (VAR) Model
(vi) Dynamic Stochastic General Equilibrium (DSGE) Model

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Brief descriptions of these models with their relative merits and demerits are presented in
Annex-3. It may be observed from the discussions that there does not exist a universal
model which holds good at all times and for all countries. There is also no general
agreement among the modelers regarding the choice of a particular model for a country.
Modelers welcome that “Let all the flowers bloom and flourish”.

Macroeconomic Modeling Specialist and other consultants did not have enough time to
review in details the existing data base in Nepal and the level of capacity in terms of both
skilled human resources and the information and communications technology (ICT) in
the government departments and in the Nepal Rastra Bank. Therefore, it is difficult at this
stage to indicate the types of models which will be most suitable for Nepal.

4.3 International Best Practices and Lessons for Macroeconomic Modeling

International best practices and the author’s own experiences in modeling in selected
developing countries in Asia and Africa (such as India, Cambodia, Mongolia,
Philippines, and the Gambia) lead to the following conclusions:

(a)A limited purpose model is better than a general purpose model.


(b)A positive (operational) model is better than a normative (theoretical) model.
(c)A policy oriented model is better than a general forecasting model.
(d)A short run/ medium term model is better than a long run model.
(e)A model with selected sectors is better than a large economy-wide model.
(f) A partial equilibrium model is better than a general equilibrium model.
(g)A behaviorist model is better than a Linear Programming optimizing Model.
(h)An econometric model is better than a Leontief Input Output Model.
(i) Models should be selected to address specific problems and objectives.

(j) It is better to depend on expert guess on the crucial variables (such as


population, weather, international food and oil prices, domestic technology,
minerals exploration etc.), which have major impact on productivity and growth
rather than completely leaving out missing data on these variables.
(k) Computerized models on social systems cannot be expected to produce precise
results. But these can be used for creating vision and indicative planning.
(l) Quantitative results need to be justified by qualitative judgments which are very
useful for policy planning.
(m) Social- political context may be treated as given in a model.
(n)Models should be tested rigorously and simulated for the real world with full
range of policy options.

(o)Modelers should specify sources of data and share basic data with others.

(p)Substantial portion of resources should be used for full documentation of the


model, so that any other group can test, calibrate and run the model.

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Nepal Macroeconomic Model- Inception Report

(q)Part of the documentation should be clear and free from statistical and
econometric jargons and mathematical squabbles for general understanding by
the non-technical audience.

(r) Stakeholders, users and policy makers should be involved in the modeling
process from the very beginning so that the model could be modified and made
more realistic.

(s) It is necessary to continually review, monitor, update, upgrade and simulate the
model to take care of changing domestic and external environment.

(t) It is better to state biases, intuitive arguments and the inherent limitations of a
model more explicitly in the model description rather than concealing.

(u)A modeler should know whom he is addressing for the presentation of his model
and who the clients for the final results are. If he is addressing senior most policy
makers, main text may concentrate on basic results and their interrelations, while
the econometric estimation details and equations with mathematical jargons may
be presented in the technical appendix.

All these dictums will be kept in view by the macroeconomic modeling specialist while
building up an appropriate model for the Nepalese economy.

4.4 Data Base

Sample period for NMEM update and DSGE Model will be from FY1984/85 to
FY2006/07 since the data for 2007/8 is not final. There will be thus 23 years of time
series data. Modeling exercise based on the actual data is more realistic and reliable than
that on estimated data, and large number of observations in a time series will be better for
obtaining more robust and reliable estimates.

The major sources of the data are the Government of Nepal, MOF, NRB and CBS. The
data for final demand, prices, Balance of payment, government budget, and money can be
obtained from the Economic Survey and budget speech of MOF, Quarterly Economic
Bulletin of NRB, and, Statistical year books of CBS. In addition to them, recent data can
be obtained from official records of these offices. But due care should be taken in using
some data from different sources because they may not be consistent.

The fiscal year of the Government of Nepal ends on 15 July. For example, FY2009
includes the time period from 16, July 2008 to 15, July 2009. The unique dating
convention makes it necessary to adjust foreign variables to maintain data coherence.

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Nepal Macroeconomic Model- Inception Report

5. A brief review of the past economic modeling exercises in Nepal

Since 1980’s, individual researchers had attempted to use statistical techniques and
econometric models for economic analysis and forecasting in Nepal.

1) In 1985, a multi-sector, economy-wide model was first introduced by Khanal,


Thapa and Elbers (1987)8.

2) In 1987, the Water and Energy Commission developed a macro model for
forecasting energy demand.

3) In 1989, a macro-economic model in the Leontief input-output framework


comprising 39 sectors was also developed to prepare long-term industrial plans
and to formulate alternative development strategies for the economy 9. The basic
objective of the model was to determine the optimum volume of investment under
an acceptable rate of inflation, acceptable fiscal deficit, realistic level of foreign
assistance, and a stipulated growth rate for per capita consumption.

4) A similar version of the macroeconomic model was also used in the formulation
of the Eighth Plan.

5) In 1992 another macro model was developed as a part of the link model for the
South Asian Association for Regional Cooperation (SAARC) countries10 to
examine the impact of regional trade on its member economies.

6) A slightly different model in the framework of the standard flow-of-funds


accounting, commonly used by the World Bank and the International Monetary
Fund, was developed for the National Planning Commission Secretariat Project.
In the model, different building blocks viz. the national accounts; the budget and
pubic sector account; the balance of payments (BOP) or the rest of the world
account; the monetary sector account; and the private sector account; was
integrated into a consistent accounting framework.

7) In 1990, a simple macroeconomic accounting framework was employed to


examine the possibility of policy coordination between exchange rate policy and
fiscal policy for more effective management of the economy11.
8
Khanal, D. R., P. J. Thapa, and C. Elbers. 1987. A Regionally Disaggregated Planning Models for Nepal.
Kathmandu: NPC/ESCAP/IDS/ISI.

9
Development Study Consultants. 1990. Policy Planning Models for the Nepalese Economy with Special
Reference to the Industrial Sector. Mimeo. Kathmandu: DSC/MOI/UNIDO.

10
Khanal, D. R. and G. N. Sharma. 1992. A Macroeconometric Model of Nepal in SAARC Link. Nagvi,
S.N.H. and S.A. Samad, eds. New Delhi: Oxford and IBH Publishing Co. Pvt. Ltd.

11
Cruikshank, E.D. and R.H. Nord. 1990. The Role of Exchange Rate Policy: The Case of Nepal.
Mimeo. Kathmandu.

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Nepal Macroeconomic Model- Inception Report

8) While the Tenth Plan was being formulated, the integrated macro and input-
output model was used to set the growth rates and the investment levels at both
the sectoral and aggregate level without disrupting macroeconomic stability.

9) Special attention should be drawn to two other macroeconomic models: Alamgir


and Ra (2001)12 and Sharma (1989). The Alamgir and Ra (2001) model projects
GDP growth by major economic sectors on the basis of growth elasticity derived
from historical data and adjusted for structural changes.

10) A common feature of the two models is that GDP is predetermined or stipulated
before estimating individual equations. These models implicitly assume that the
supply side determines aggregate output, and they predict each endogenous
variable in a way that is consistent with the given output level.

11) There had recent attempts under technical assistance by ADB to develop a
medium a medium size Macroeconomic Model (MEM). A part of TA for
Strengthening Institutional Capacity for Public Debt Management, ADB (Ra and
Rhee 2005) supported the Government in developing a MEM in 2005– known as
Nepal Macroeconomic Model (NMEM)— on the basis of the standard Keynesian
income–expenditure approach in which gross domestic product (GDP) is
determined endogenously.

12) Apart from being used by the Government for debt sustainability analyses, Nepal
Rasta Bank (NRB) has also been using the NMEM for economic forecasting.

13) Subsequently to that Khanal and Kane (2005) had utilized a MEM to analyze
reduction of domestic poverty, and

14) Bhattarai (2007) had produced an applied dynamic general equilibrium model for
Nepal.

15) In recent years Nepal Rastra Bank has engaged itself actively for developing its
own MEM which would be consistent with the vision and mission of the Bank.
The model was developed by the Macroeconomic Modeling Unit (MMU) of the
NRB (2007), Research Department’s Economic Analysis Division as a part of its
macroeconomic modeling activities.

From the above review it follows that the state of the macroeconomic modeling in Nepal
is still at an experimental and learning stage. There are a few examples of
macroeconomic modeling for the purpose of policy planning and formulation of

12
Alamgir, M., and S. Ra. 2001. Nepal: Debt Sustainability and Country Risk Analysis. Manila:
ADB.

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economic plan. But these were not done on a sustainable, comprehensive and continual
basis. There was also lack of adequate capacity building in the respective agencies.

Besides, the utility of NMEM has become limited due to major structural changes in the
Nepal’s economy, and major revisions of key macroeconomic data (such as National
Accounts, Price Statistics, Government Finance Statistics and the Balance of Payments
over the years) due to changes in base period and basic concepts. Therefore, the NMEM
developed by ADB needs to be reviewed and upgraded. In addition, other econometric
models such as the Dynamic Stochastic General Equilibrium (DSGE) model need to be
developed to examine the relative merits and demerits of both these models.

Considerable efforts are, therefore, required for the development of new modeling
techniques with a focus on the direct and practical policy applications by the Nepal
Rastra Bank, Ministry of Finance and the National Planning Commission (NPC).

The basic purpose of the present technical assistance of the ADB is to remove these
deficiencies in macroeconomic modeling and to strengthen technical capability in the
NRB, MOF, NPC and CBS for model building and its use for policy planning.

6. Analytical Framework of a General Macroeconomic Model

6.1 Basic Objectives

The basic purpose is to build an appropriate and stable model, depicting the underlying
structure of the Nepalese economy, which can be used to forecast major macro economic
variables for both the short-term (one year) and medium term (five years) for preparation
of budget and national plan and formulation of monetary and fiscal policies. The
projections will also form the basis for preparing the macroeconomic and fiscal envelope
by the Nepal Rastra Bank to be provided to the Ministry of Finance for pre-budget
consultations and requirements.

Here we present a general framework for a macroeconomic model, which is consistent


with the concepts under the UN System of National Accounts (UN-SNA), and the IMF
Government Finance Statistics (GFS), Balance of Payments (BOP) Statistics and the
Monetary-Financial Statistics (MFS). This model produces the baseline scenario of the
macro economy disaggregated into the five inter-related accounts as indicated below:

(i) Real Sector and National Accounts


(ii) Government Sector (Fiscal Account)
(iii) Monetary and Financial Sectors
(iv)External Sector
(v) Prices, Interest Rates and Exchange Rate and

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6.2 Model Structure and Analytical Framework

The basic structures of these sub-models and their interrelations are depicted in the form
of a flow diagram in Box-6.1. The linkages between key aggregates of the national
accounts and the balance of payments flows can, by the use of symbols, be summarized
algebraically within a savings/investment framework.

National Accounts System (NAS)

GDPFC = Real GDP at constant FC


= GDPAG + GDPIND + GDPSER
GDPAG = Agricultural GDPFC
GDPIND = Industrial GDPFC
GDPSER = Services GDPFC
C = private consumption expenditure
G = government consumption expenditure
I = gross domestic investment
S = gross saving
X = exports of goods and (non-factor) services
M = imports of goods and (non-factor) services
NFY = net factor income from abroad
GDP = gross domestic product
GNP = gross national product
GNDY = gross national disposable income

Balance of Payments (BOP)

CAB = current account balance in the balance of payments


NCT = net current transfers
NKT = net capital transfers
NPNNA = net purchases of non-produced, non-financial assets
NFI = net foreign investment or net lending/ net borrowing vis-à-vis the rest of the world
NKA = net capital and financial account (i.e., all capital and financial transactions
excluding reserve assets)
RT = reserve asset transactions

Government Finance Statistics (GFS)

R = Revenue = T + NT
T = Tax revenue
NT = Nontax revenue
GR = Grants
GEXP = Government expenditure and net lending = G + GK
G = government consumption expenditure
GK = GCE + ND
GCE = Government capital expenditure

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Nepal Macroeconomic Model- Inception Report

ND = Net lending
GFD = Gross Fiscal Deficit
= (R+GR) - GEXP

Monetary-Financial Statistics (MFS)

MD = Demand for money = NFA+CRG + CRP + OI


MS = Supply of money = DD + TD + CN
CRG = Credits to the government and public enterprises
CRP = Credits to the private sector
NFA = Net foreign assets
OI = Other items
DD = Demand deposits
TD = Time deposits
CN = Currency and notes in circulation

Prices, Interest Rates and Exchange Rates

CPI = Consumer Price Index


WPI = Wholesale Price Index
GDPDF = GDP Deflator
INT = Rate of interest
PLR = Prime lending rate
FDR = Fixed deposit rate
ER = Exchange rate of Nepalese Rupee

The Macroeconomic Balance Equations stand as follow:

GDP = C + G + I + X–M (1)


(X–M = balance on goods and services in the balance of payments)
GNP = GDP + NFY (2)
CAB = X – M + NFY+NCT (3)
GNDY = C + G + I + CAB (4)
GNDY = C + G + S (5)

Equating (4) and (5) we get:


S – I = CAB i.e. saving-investment gap (resource gap) equals CAB (6)

S – I + (NKT – NPNNA) = CAB + (NKT–NPNNA) = NFI (7)

(NKT – NPNNA) = balance on the capital account of the balance of payments

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Nepal Macroeconomic Model- Inception Report

Box-6.1: Basic Structures of Macroeconomic Sub-models and Inter-linkages

National Accounts
Real Sector (Supply Side) CENTRAL GOVERNMENT
GDP = Σ GDPi Revenues
Where GDPi = GDP of i-th sector • Taxes and non-taxes
• Grants
Demand/ Expenditure Side Expenditures
NMEM’s
• Private consumption • Current
• Gen. govt. consumption • Capital
• Gen. govt. investment Overall balance
• Private investment Financing
• Exports of goods and • Domestic financing (net)
non-factor services • Banking system
• Imports of goods and • Nonbanking sector
non-factor services • External financing (net)

Balance of Payments MONETARY SECTOR


CURRENT ACCOUNT Monetary Authorities
• Exports of goods and • Net Foreign Assets
non-factor services Net domestic assets:
• Imports of goods and • Net credit to central govt.
non-factor services • Credit to banks
• Factor services (net) • Other items (net)
• Transfers (net) • Reserve money
• Official
• Private grants Deposit Money Banks
• Remittances • Banks' reserves
• Net Foreign Assets
CAPITAL ACCOUNT Net domestic assets:
• Net credit to govt.
Direct investment • Credit to private sector
Medium/ long-term • Other items (net)
capital flow (net) • Liabilities to monetary
Short-term capital (net) authorities
Overall balance Private sector deposits
Change in net foreign assets

CPI Inflation, GDP Deflator,


Interest Rates and Exchange Rate

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Nepal Macroeconomic Model- Inception Report

Interrelationship between the internal and external sectors of an economy can be seen in
greater detail by distinguishing between the private and government sectors. Private
saving and investment (Sp and Ip) and government saving and investment (Sg and Ig)
are identified as:

S–I = Sp+Sg–Ip–Ig (8)

Use of the definition of the external current account from equation (1) then gives:
CAB = (Sp–Ip) + (Sg–Ig) = S–I (9)

Equation (9) shows that the private savings-investment balance plus the government
fiscal balance equals the current account balance. It also implies that, if government
sector dissaving is not offset by net saving of the private sector, the current account will
be in deficit. More specifically, the equation shows that the budgetary position of the
government (Sg-Ig) may be an important factor influencing the current account balance.

Government deficit is financed by borrowing from the domestic sector, borrowing from
the external sector and borrowing from the central bank. All these factors have influences
on the domestic capital and financial markets and also on the balance of payments.

Economists generally agree that a persistent fiscal deficit may ultimately spill over the
current account deficit in the balance of payments. On the converse, a sustained current
account deficit may reflect persistent government spending in excess of receipts, and
such excess spending may suggest that fiscal tightening is the appropriate policy action to
tackle both fiscal and balance of payments problems.

We also know that


CAB = NKA+RT = S–I (10)

Equation (10) shows that the current account balance is necessarily equal (with sign
reversed) to the net capital and financial account balance plus reserve asset transactions.
This relationship shows that the net provision, as measured by the current account
balance, of resources to or from the rest of the world must—by definition—be matched
by a change in net claims on the rest of the world.

It may be useful to rewrite CAB as:


S–I = CAB = TB+SB+FIB+TRANB = NKA+RT (11)

Where
TB = Merchandise trade balance = Merchandise Exports – Merchandise Imports
SB = Non-factor service balance (travel, tourism, financial, business, ICT etc.)
FIB = Factor income balance (interest, dividends, wages, rent, royalties etc.)
TRANB = current transfer balance (official grants, private grants, remittances)

For Nepal, in general, TB and SB are negative, while FIB and TRANB are positive.

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Nepal Macroeconomic Model- Inception Report

6.3 Specification of the Model and Work Plan

While keeping these basic identities and macroeconomic balance equations intact,
various variables in the model will be categorized either as exogenous variables or
endogenous variables. While exogenous variables will be determined outside the model,
suitable econometric relations will be specified for the endogenous variables on the basis
of standard economic theories.

Items in different sub-models will be estimated and calibrated by suitable econometric


techniques and tested on the basis of standard goodness of fit statistics. The models will
be fully developed and documented in the subsequent reports.

The proposed Work Plan Matrices of the Consultants are presented in Annex-7.1 to
Annex-7.4. Major Work Plan Milestones are summarized below:

1. Preparation of the Draft Inception Report by 10 September 2009


2. Finalization of the Inception Report 22 September 2009.
3. Review the NMEM and identify deficiencies and their causes by 09 Oct 2009
4. Conduct research & explore data sources to upgrade the NMEM by 09 Oct 2009

5. Report on the choice of software and hardware by 16 Oct 2009

6. Set up Workstations for Software/ hardware Testing by 2nd January 2010

7. Finalize choice and purchase of software/hardware by 15th January 2010

8. Finalize the upgraded NMEM by 31 January 2010

9. Undertake research to develop a DSGE-type model for Nepal by 24 Feb 2010

10. Conduct multi-stakeholders’ seminars/ workshops on the features of the two models by
15 May 2010

11. Preparation of macroeconomic and fiscal envelope for the Ministry of Finance as pre-
budget inputs for preparation of the Budget for 2010-2011 by 31 May 2010

12. Develop and calibrate the DSGE-type model by 31 May 2010.

13. Develop a user manual, including calibration methodology, to undertake quantitative


macroeconomic analysis using the DSGE model by 25 June 2010

14. Conduct seminars/ workshops on the features of the two models by 30 Sep 2010

15. Provide on-the-job training to three staff from each of the agencies— NRB, CBS, NPC,
MOF and the Department of Economics, Tribhuvan University, and other relevant
agencies (staff will be selected in close coordination with the executing agency, Steering
Committee, and the Technical Committee) by 30 Sep 2010.

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Nepal Macroeconomic Model- Inception Report

7. Brief Descriptions of Works

7.1 Updating the Nepal Macroeconomic Model developed by ADB

In 2005 ADB (Ra, Sungsup and Chang Young Rhee 2005) developed the Nepal
Macro-economic Model (NMEM) and simulated the model to carry out alternative
scenario analysis. The model was also calibrated to measure the economic costs of
conflict in terms of the effect of declining development expenditures on economic growth
(Ra, Sungsup and Bipul Singh 2005).

NMEM is a medium-sized annual Keynesian model and consists of 20 behavioral


equations and 17 identities. Of the 59 variables in the system, 37 are endogenous and 22
are exogenous. There are 5 building blocks in the NMEM viz. final demand, prices, credit
and money, government, and the balance of payments blocks. Final demand is the sum of
private consumption, government consumption, private fixed investment, government
fixed investment, increase in stock or inventory, and net exports. In NMEM, development
expenditure is a determinant for the private fixed investment, public fixed investment and
public consumption.

A critical review of the model leads to the following limitations:

(a) Model considers only the demand side of GDP, but does not consider the supply
side of the real sectors.
(b) Similarly, money, credit and price blocks were not fully developed and did not
consider the supply side and the role of expectations.
(c) The Government block was the weakest block with only equation for the non-tax
revenue and all other variables were defined by simple accounting identities.
Basically, all the fiscal variables such as taxes, current and capital expenditure are
treated as policy variables and left to be decided by the policy makers. This is not
a very convincing assumption because taxes and government expenditures also
depend on economic prospects, composition of GDP and many other variables.
(d) Similarly, balance of payments block were not well developed. It considered
only merchandise exports and merchandised imports but did not endogenize the
other components in the current account (such as services and remittances). In the
capital account, loans and amortization was endogenized, but the underlying
econometric relations are less convincing.
(e) The model also needs to be updated and upgraded on the basis of new data
available for the national accounts and balance of payments.

The NMEM will be reviewed more critically and modifications will be suggested in the
next report. While doing so, due consideration will be given to the availability data base,
statistical test and calibration techniques, computer algorithms, and available hardware
and software capabilities, and technical manpower in the NRB, MOF and other budgetary
agencies which are likely to use the updated NMEM for budgeting, planning and
monetary and financial programming.

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Nepal Macroeconomic Model- Inception Report

7.2 Building up of a Dynamic Stochastic General Equilibrium Model

The model has been described fully with its relative merits and demerits in terms of
objectives, data requirements and test and calibration techniques in section 3.13 in the
Annex-3. As the name indicates, DSGE models are dynamic, studying how the economy
evolves over time. They are also stochastic, taking into account the fact that the economy
is affected by random shocks such as technological change, fluctuations in the price of
oil, or errors in macroeconomic policy-making.

International best practices like the ECB Model and the USA Model will be studied and
suitable model will be formulated and estimated for forecasting and planning by the
NRB, NPC and the Ministry of Finance.

7.3 Capacity Building and Training

The consultants shall work in close collaboration with the concerned authorities in the
government department viz. MOF, CBS, NPC and the National Rasta Bank with a view
to transferring knowledge and equipping the staff with the skill required to manage and
maintain the models in future. Consultants will demonstrate the use of the models by
simulating actual policy questions raised by the authorities.

After the Models have been fully developed, macroeconomic modeling experts shall
carry out a series of simulations to check for consistency, predictability and reliability of
both the models, and shall validate both the models at multi-stakeholders workshop.
Macroeconomic modeling experts will also advise the authorities on the most appropriate
hardware and user-friendly software package for the purpose of maintaining the models.

7.4 Support the IT Group for Software and Hardware Selection

In consultation with the Team Leader, local econometrician and the local IT Specialist
jointly made a Rapid Survey on the current status of ICT capabilities in the MOF, CBS,
NPC and NRA. As per their assessment, all the four agencies have rich database, well
developed website, and reasonable hardware and software capabilities. However, licenses
of major software have expired and the software is outdated and need upgrading.
Agencies do not have uniform operating systems and software capabilities. All these
issues will be studied in details and suitable recommendations will be given.

The main observations of the Consultants drawn from the Rapid Survey are summarized
below:

a) Data Bank and Warehouse: All four agencies regularly update their database and
maintain soft version of data in various software depending on the size and nature of the
database. CBS maintains database mostly in MS-Excel, Oracle, STATA and SPSS; NRB
in MS-Excel and SPSS; MoF in Oracle and MS-Excel; and NPC in SPSS, Oracle and
MS-Excel. For time-series data on major Macro variables, all four agencies use MS-

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Nepal Macroeconomic Model- Inception Report

Excel and share their data via emails. However, time interval and frequency of data
publication varies from agency to agency depending on the nature of data. There is no
uniformity in the storage and software format among the agencies.

b) Capacity for Data Analysis: Capacities of agencies differ in terms of data analysis
skill. CBS is very competent in statistical analysis but lags in macro-econometric
forecasting. NRB is equipped with both statistical techniques and limited macro-
econometric modeling skills. NRB staffs are technically competent and use econometric
methods in course of their researches, but such activities are not systematically followed
due to pressures from routine works. NPC has limited capacity on statistical analysis but
has experience of modeling exercises that were discontinued due to work pressures and
limited designated staffs. MOF is less competent in statistical analysis and econometric
modeling skills as compared to other agencies.

c) Capacity for Data Retrieval: Capacities of the four agencies differ in terms of data
retrieval. While four agencies have capacity to retrieve data from MS-Excel, CBS, NRB
and NPC are partially equipped to retrieve data from SPSS and Eviews. They also have
some knowledge on how to transfer the database from one software to another software.

d) Data Availability in Web: All four agencies have their own websites, which are
updated on regular basis to upload new data. The data are generally uploaded either in
MS-Excel format or in Adobe Reader files.

e) Hardware Capacity: All four agencies do have sufficient computers of good quality
that are sufficient to run software programs like EXCEL, SPSS, STATA and Eview and
to use the facility of internet/ emails.

f) Availability of Software: The status of the four agencies is mixed in terms of


availability of software as indicated below. It is observed that most of the software
versions are outdated and in many cases the licenses have expired.

Agencies Available Software


CBS STATA, SPSS and MS- Excel
NRB Eviews 3.1, SPSS and MS- Excel
NPC Eviews, SPSS and MS- Excel
MOF MS- Excel and Eviews 4.1

g) Human Resource: CBS staffs have very good statistical skill but very few of them
have the experience of modeling. NRB staffs, in general, possess very good statistical and
modeling skill. NPC has very limited human resource but the available few are very
competent in statistical and modeling shill. MOF has a very small pool of human
resource having sufficient statistical and modeling skills.

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Nepal Macroeconomic Model- Inception Report

7.5 Preparation of Manuals and Organizing Workshops

As discussed earlier, substantial time will be spent to prepare manuals and full
documentation on basic concepts, structure of the models, data base, computer
algorithms, test and calibration techniques. portion, so that any other group can test,
calibrate and run the model, even after the present modelers and consultants have left the
modeling project. Once the Models are fully developed and calibrated, results will be
presented in the multi- stakeholders Workshops.

7.6 Preparation of the Inception Report

This is the Inception Report being prepared by the International Modeling Specialist in
consultation with the major stakeholders and vital inputs from the local consultant. The
Inception Report is expected to be completed by the 10th September, 2009, well before
the stipulated time of one month as envisaged under the Terms of Reference. List of
officers consulted for preparation of this report is giver in Annex-8.

7.7 Preparation of the Quarterly Progress Report

The modeling works with all its components are required to be completed in six person
months (132 working days) on intermittent basis in four phases during 15 months from
August 2009 to October 2010. The Work Plan Matrices of the Consultants presented in
Annerx-6.1 to Annex-6.4 clearly indicate the distinct four phases of the work which will
be completed within stipulated time. The Progress Report will be submitted after
completion of each phase of works.

7.8 Preparation of the Terminal Report

At the end of the Project, a Terminal Report will be prepared indicating the overall scope
and achievements of the project, constraints faced, lessons learnt, issues and challenges
for way forward, and suggested roll out plan so that the project comes to a logical end.

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Nepal Macroeconomic Model- Inception Report

8. Review and Upgrading the Nepal Macroeconomic Model

8.1. Review of the Nepal Macroeconomic Model developed by ADB

As mentioned in section 7.1 earlier, ADB supported the Government of Nepal in


developing a comprehensive macroeconomic model in 2005—Nepal Macroeconomic
Model (NMEM)—as a part of TA for Strengthening Institutional Capacity for Public
Debt Management. Apart from being used by the Government for public debt
sustainability analyses, Nepal Rasta Bank (NRB)—the central bank of Nepal—has also
been using the NMEM for economic forecasting. However, the NMEM’s utility has
become limited due to some major developments in recent years.

The major characteristics of the NMEM are:

(a) The NMEM is a basically Keynesian income-expenditure model in which the


demand side determines GDP.
(b) The supply side is not explicitly specified as the aggregate production
function is not estimated.
(c) Its basic features are drawn from the Korea Development Institute (KDI)
macro model that had been used to design successive 5-year economic
development plans in Korea. Due to the lack of quarterly data in Nepal the
NMEM is an annual model while the KDI used a quarterly macro-
econometric model.
(d) The NMEM is a mid-sized model with 37 equations. A medium-sized model
has an advantage in policy analysis as it incorporates more detail of the
structure of the economy.
(e) The NMEM consists of 20 behavioral equations and 17 identities. Of the 59
variables in the system, 37 are endogenous and 22 are exogenous. The NMEM
distinguishes policy variables from simple exogenous variables since these
policy variables are different from simple exogenous variables that are
determined by non-economic forces or foreign sectors. Taxes, regular
expenditures, development expenditures, foreign borrowing, and the exchange
rate were taken as policy variables in the NMEM.
(f) Given the peg of the Nepalese rupee to the Indian Rupee, monetary variables
are not considered as policy variables. Table-8.1 lists the exogenous,
endogenous and policy variables and Table-8.2 presents the set of best fitted
equations for the model.
(g) The NMM attempts to incorporate Nepal’s strong economic ties with India in
international transactions although economic relationships with other
countries are also becoming important.
(h) The impact of the exchange rate on trade in Nepal is quite limited since the
Nepalese rupee is pegged to the Indian rupee and India is the major trading
partner of Nepal. The exchange rate variables were incorporated in the trade
equations since the changes in the exchange rate with respect to the US dollar

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Nepal Macroeconomic Model- Inception Report

can affect trade with the rest of world by changing the relative prices with
other countries.

The Nepal Macro-economic Model (NMEM) was tested and calibrated on the basis of
time series data for the sample period from FY1975 to FY2004. Then the model was
simulated to carry out alternative scenario analysis for formulation of the Tenth Plan. The
model was also calibrated to measure the economic costs of conflict in terms of the effect
of declining development expenditures on economic growth (Ra, Sungsup and Bipul
Singh 2005).

There are 5 building blocks in the NMEM viz. final demand, prices, credit and money,
government, and the balance of payments blocks. Final demand is the sum of private
consumption, government consumption, private fixed investment, government fixed
investment, increase in stock or inventory, and net exports. In NMEM, development
expenditure is a determinant for the private fixed investment, public fixed investment and
public consumption.

Limitations of the Model of the Model have already been discussed in section 7.1. So
these are not repeated here. In brief Model considers only the demand side of GDP, but
does not consider the supply side of the real sectors, which put basic constraints on the
growth and development of a developing country like Nepal. In addition, monetary,
financial and price blocks, government block, and balance of payments block were not
fully developed and did not consider the supply side and the role of expectations of
economic agents. The model also needs to be updated on the basis of new data available
for the national accounts and balance of payments.

The utility of NMEM in the national polity analysis has been limited due to the
following reasons:
− The structure of Nepal’s economy has changed significantly. Agriculture’s
contribution to GDP has declined fast whereas the services sector’s contribution has
grown rapidly compared to other sectors of non-agriculture sectors. It is interesting to
note that the industry’s share of GDP has remained more or less unchanged. The
national accounts also underestimate certain incomes, such as migrant workers’
remittances, which have grown sharply since 2004.
− There have been some major revisions of basic concepts and standards of key
macroeconomic variables such as national accounts, government finance, balance of
payments and prices since the NMEM was developed.
− In view of these changes, it is necessary to upgrade the NMEM for analytical work
and macroeconomic forecasting.

In the following section, we specify a modified and upgraded macroeconomic model for
Nepal. While doing so, due consideration has been given to the availability new data
base, up-to-date statistical test and calibration techniques, computer algorithms, and
available hardware and software capabilities, and technical manpower in the NRB, MOF
and other budgetary agencies which are likely to use the updated NMEM for budgeting,
planning and monetary and financial programming.

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Nepal Macroeconomic Model- Inception Report

Table 8.1: List of Variables in ADB NMEM (2005)

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Nepal Macroeconomic Model- Inception Report

Table-8.2

The Structure of the ADB Nepal Macroeconomic Model (NMEM)

Independent Fitted Equations


Variables
1. Private
Consumption

2. Government
Consumption
3. Private
Fixed
Investment

4. Government
Fixed
Investment

5. Exports of
goods and
services
6. Imports of
goods and
services
7. Consumer
Price Index
8. GDP
Deflator
9. Net Foreign
Assets
10.Private
Domestic
Credit
11.Government
Domestic
Credit

12.Non-tax
Revenue

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Nepal Macroeconomic Model- Inception Report

13.Merchandis
e Exports

14.Merchandis
e Imports

15.Foreign
Loans and
Official
Grants

16.Amorti-
zation

17.Foreign
Loan
Disburse-
mint
18.Grant
Disburseme
nt

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Nepal Macroeconomic Model- Inception Report

8.2 An Upgraded Macroeconomic Model for Nepal

As described in Section 6 earlier the proposed model has the following blocks:

(1) National Accounts System (NAS) - Supply and Demand Side


(2) Government Finance (GF)
(3) Balance of Payments (BOP)
(4) Monetary-Financial Sectors (MFS)
(5) Prices, Interest Rates and Exchange Rates

8.2.1 National Accounts Block

(a) Supply Side of GDP

Real GDP at constant factor cost will be projected for the broad sectors
of the economy. List of variables, their types and notations are
indicated in the following table:

List of Variables Type of Variable Notation


A. Population (million, as on 2 July Exogenous POP
Population growth rate (% per annum) Exogenous POPGR
Work force (age 15-65 years) Exogenous WF
Employment (in '000) Exogenous L
Total employment = LAG + LIND + LSER Identity L
Agriculture Exogenous LAG
Industry Exogenous LIND
Services Exogenous LSER
B. GDP: Supply Side
1. GDP const FC (Mill. NR) =1.1+1.2+1.3 Identity GDP
1.1 Agriculture and allied Endogenous GDPAG
1.2 Industry = 1.2.1+1.2.2+1.2.3+1.2.4 Identity GDPIND
1.2.1 Manufacturing Endogenous GDPMANF
1.2.2 Mining and quarrying Endogenous GDPMINQ
1.2.3 Electricity, gas, water supply Endogenous GDPELEC
1.2.4 Construction Endogenous GDPCONST
1.3 Services = 1.3.1+1.3.2+1.3.3+1.3.4 Identity GDPSER
1.3.1 Trade, hotels and restaurants Endogenous GDPTRADE
1.3.2 Transport, storage, commn. Endogenous GDPTRANS
1.3.3 Financial, real estate, business Endogenous GDPFIN
1.3.4 Community, social, personal Endogenous GDPCSP
1. GDP const FC (Mill. NR) =1.1+1.2+1.3 Identity GDP
2. (Plus) Indirect taxes less subsidies Endogenous INDT
3. GDP at cons mp (Mill. NR) = 1 + 2 Identity GDPMP
4. GDP at current mp (Mln NR) Endogenous GDPN

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Nepal Macroeconomic Model- Inception Report

Data Base

The basic data on selected variables for the period from the fiscal year
1984/1985 (annual data the year 1984/1985 ending 15 July 1985) to
the fiscal year 2007/2008 (annual data for the year 2007/2008 ending
15 July 2008) will be obtained from the respective primary sources i.e.
national accounts from the CBS, balance of payments and monetary
and financial statistics from the NRB and the public finance statistics
from the MOF.

Methodology

Basic methodology used is the time series analysis and to estimate


historical growth rates on the basis of three kinds of time trends
growth rates viz., least squares time trend growth rate, exponential
growth rate and simple average annual growth rate.

Historical Growth Rates

To start with, we estimate the average historical growth rate for each
sub-sectors of GDP viz. GDPAG, GDDMANF, GDPMINQ, GDPELEC,
GDPCONST, GDPTRADE, GDPTRANS, GDPFIN and GDPCSP. The
following three kinds of growth rates are calculated on the basis of the
past data from 1984/1985 to 2007/2008.

(a) Least-squares time trend growth rate

The IMF uses the Least-squares growth rates to forecast the country
growth rates in their World Economic Outlook (WEO) published twice in
a year, wherever their is past data for at least 9 years to permit a
reliable calculation. The least-squares growth rate, r, is estimated by
fitting a linear regression trend line to the logarithmic annual values of
the variable in the relevant period. The regression equation takes the
form

Ln Yt = a + bt

which is equivalent to the logarithmic transformation of the compound


growth equation,

Yt = Yo (1 + r)t

In this equation, Y is the variable, t is time, r is the trend growth rate,


Ln is the natural logarithm operator, and a = log Yo and b = Ln (1 + r)
are the parameters to be estimated.

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Nepal Macroeconomic Model- Inception Report

If b* is the least-squares estimate of b, the average annual growth


rate, r, is obtained as

r = [exp(b*) – 1] and is multiplied by 100 to express it as a percentage.

The calculated growth rate is an average rate that is representative of


the available observations over the entire period. It does not
necessarily match the actual growth rate between any two years.

(b) Exponential growth rate

The exponential growth rate between two points in time for a variable
is calculated from the following equation

r = Ln (Yn /Y1)/n

where Yn and Y1 are the last and first observations in the period, n is
the number of years in the period, and Ln is the natural logarithm
operator. This growth rate is based on a model of continuous and
exponential growth between two points in time. It does not take into
account the intermediate values of the series.

(c) Average of Annual Growth rates

Average Annual Growth Rate (µ) = ∑ GRi /n


GRi = 100 * (Yi / Yi-1 -1) for i=1, 2, … n for the years 1985, 1986, ...….. 2008.
CV = 100 * SD/ µ
SD² = Σ (GRi - µ ) ² / n
Where Ln stands for natural logarithm, GRi for growth rate for the i-th year, CV for
coefficient of variation and SD for standard deviation.

In general, the least squares trend growth rate is expected to be lower than the
exponential growth rate, which in turn is expected to be lower than the average annual
growth rates for most of the variables.

It may also be possible that annual growth rates are highly volatile with high standard
deviation (SD) and co-efficient of variation (CV), and therefore the average annual
growth rate cannot hold good for the medium and long term.

(d) Base Line Time Trend Projections

The projections of sectoral value added for the years 2009-2015 are done on the basis of
the trend growth rate, which happens to be the minimum of these three types of growth
rates. However, if for any variable, there is high CV (say exceeding 100%), the projected
growth rate is modified on the basis of the following formula:

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Nepal Macroeconomic Model- Inception Report

Projected growth rate = Trend growth rate minus 25 percent of SD.

The same methodology is used to project net indirect taxes (i.e. indirect taxes less
subsidies and transfers). Thus we have,

GDPt = GDPAGt + GDPINDt + GDPSERt


GDPINDt = GDPMANFt+GDPMINQt+GDPELECt+GDPCONSTt
GDPSERt=GDPTRADEt+GDPTRANSt+GDPFINt+GDPCSPt
GDPMPt = GDPt + INDTt

Projections for future

In general, we use the following equation for forecasting:

Yt = Yo (1 + r)t

Where Y = GDPAG and other sectors


0 = Base year 2008/09
T = 1, 2, 3 for years 2009
Nominal GDP at current market prices is projected by the following equation:
GDPNt = GDPt (1 + 0.01 * INFGDPt)
Where INFPGDPt is the projected inflation in terms of GDP deflator for
the year t.

(b) Demand Side of GDP

Demand side is projected at current market prices because decisions by economic agents
are always made on the basis of current market prices. List of variables, their types
and notations are indicated in the following table:

GDP at current mp (Mln NR) Identity GDPN


=a+b+c+d+e-f+g
(a) Private consumption Endogenous CP
(b) Government consumption Endogenous CG
(c) Gross fixed capital formation = (i)+(ii) Identity FC
(i) Gross fixed cap. Formation by govt. Endogenous FCG
(ii) Gross fixed cap. Formation by private Endogenous FCP
(d) Change in stocks Endogenous ST
(e) Exports of goods and services Endogenous XGS
(f) Imports of goods and services Endogenous MGS
(g) Statistical error in GDPN estimation Endogenous SDGDP
Investment (at current prices)=a+b+c Identity INV
(a) Agriculture and allied Endogenous INVAG
(b) Industry Endogenous INVIND
(c) Services Endogenous INVSER
Other explanatory variables (current prices)
Tax revenues of the government Exogenous TAX

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Nepal Macroeconomic Model- Inception Report

Total revenues of the government Exogenous REV


Time = 1, 2, .. for the years 1984/85, … Exogenous Time
Inflation rare in terms of WPI Exogenous INFWPI
Bank credits to the private sector Exogenous BCP
Bank credits to the public sector Exogenous BCG
Fixed ratio of stocks/ inventories to total Exogenous K
gross fixed capital on the basis of past data
Real exchange rate of Nepalese Rupee in Exogenous REXR
terms of US dollar

Nominal GDP is determined by the usual balance equation. The other equations are
specified below.

GDPNNt = CPt + CG t + FCPt + FCG t + STt + XGSt – MGSt + SEGDPt

Ln(CPt) = α + β 1 Ln(GDPNt-TAXt) + β 2 Ln(POPt) + β 3 Ln(CPt-1) + β 4 Time

Ln(CGt) = α + β 1 Ln(REVt) + β 2 Ln(GDPNt) + β 3 Ln(CGt-1) + β 4 Time

Ln(FCPt) = α + β 1 Ln(GDPNt-TAXt) + β 2 Ln(INTt-INFWPIt) + β 3 Ln(BCPt)


+ β 4 Ln(FCPt-1) + β 5 Time

Ln(FCGt) = α + β 1 Ln(GDPNt-TAXt) + β 2 Ln(INTt-INFWPIt) + β 3 Ln(BCGt)


+ β 4 Ln(FCGt-1) + β 5 Time

FCt = FCGt + FCPt


STt = k. FCt

Ln (XGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(XGSt-1) + β 4 Time


Ln (MGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(MGSt-1) + β 4 Time

SEGDPt = GDPNt – [CPt + CG t + FCPt + FCG t + STt + XGSt – MGSt]

8.3 Government Finance Block

List of variables, their types and notations are indicated in the


following table:

Central Govt Operations (Billion NR)


1.Total Revenue and grants = 1.1+1.2 Identity TRG
1.1 Total revenue = (a) + (b) Identity R
(a) Tax revenue = DT + IDT Identity T
-- Direct taxes Endogenous DT
-- Indirect taxes Endogenous IDT
(b) Nontax revenue Endogenous NT
1.2 Grants Exogenous GR

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Nepal Macroeconomic Model- Inception Report

2. Total Expenditure and net lending = Identity GEXP


2.1+2.2
2.1 Current expenditure = (a) + (b) Endogenous CG
(a) Wages and salaries Endogenous WS
(b) Other charges (OC) Identity CG-WS-INT
(c) Interest payments Endogenous INT
2.2 Capital expenditure and net lending = a+b Identity GK
(a) Capital expenditure Endogenous FCG
(b) Net lending Endogenous ND
3. Current A/C Balance =1.1 - 2.1 (a) Identity CABGF
4. Gross Fiscal Balance = 1-2 Identity GFB
5. Primary Balance = 4 - Interest payments Identity PB

The proposed equations stand as follow:

Ln(DTt) = α + β 1 Ln(GDPNt-GDPNAGt) + β 2 Ln(PGDPt) + β 3 Ln(DTt-1) + β 4


Time

Ln(IDTt) = α + β 1 Ln(GDPNt) + β 2 Ln(PGDPt) + β 3 Ln(IDTt-1) + β 4 Time

Ln(NTt) = α + β 1 Ln(GDPNt) + β 2 Ln(PGDPt) + β 3 Ln(NTt-1) + β 4 Time

GRt = Grants are estimated on the basis of historical growth rates as described in earlier
section adjusted by current information by the government

Ln(CGt) = α + β 1 Ln(REVt) + β 2 Ln(GDPNt) + β 3 Ln(CGt-1) + β 4 Time

Ln(WSt) = α + β 1 Ln(REVt) + β 2 Ln(WSt-1) + β 3 Time

INT = Interest payments are estimated on the basis of projected profile of domestic and
external public debt and negotiated terms and conditions for interest payments

OC = CG-WS-INT

Ln(NDt) = α + β 1 Ln(Rt) + β 2 Ln(GDPNt) + β 3 Ln(NDt-1) + β 4 Time

CABGF = Current account balance in government finance = TRG-CG


GFD = TRG- GEXP
PB = GFD-IINT
8.3 Balance of Payments Block

List of variables, their types and notations are indicated in the


following table:

Balance of Payments (Million US$) Type of Variables Notation


Goods balance = XG-MG Identity GB
Exports of goods f.o.b.=XGIND+XGCH+XGR Endogenous XG

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Nepal Macroeconomic Model- Inception Report

(a) Exports of goods to India Endogenous XGIND


(b) Exports of goods to China Endogenous XGCH
(c) Exports to others Endogenous XGR
Imports of goods c.i.f.=MGIND+MGCH+MGR Identity MG
(a) Imports of goods from India Endogenous MGIND
(b) Imports of goods from China Endogenous MGCH
(c) Imports to others Endogenous MGR
Non-factor services balance = SCR-SCDB Identity SB
(a) Credits Endogenous SCR
(b) Debits Endogenous SDB
Factor incomes balance = FICR-FIDB Identity FIB
(a) Credits Endogenous FICR
(b) Debits Endogenous FIDB
Transfers Balance = (a)+(b)+(c) Identity TRB
(a) Official grants, net Exogenous GR
(b) Private, net Endogenous TRP
(c) Remittances Endogenous REM
Current account balance Identity CAB
(CAB)=GB+SB+FIB+TRB
Exports of goods & services Identity XGS
Imports of goods & services Identity MGS
Capital and financial account
Official loans, net = DISB-AMORT Identity DISB-AMORT
Disbursement Exogenous DISB
Amortization (AMORT) Exogenous AMORT
Private capital inflow Identity PRCAP
FDI, net Endogenous FDI
Other investment, net Endogenous OINV
Errors and omissions Endogenous EBOP
Capital and Financial Balance Identity CAPB
Overall balance = OB Identity CAB+CAPB
Foreign Exch reserve at the end period Identity FER
Equivalent to months of imports Identity MM

The equations stand as follow:

Ln(XGt) = α + β 1 Ln(GDPNt) + β 2 Ln(XGINDt) + β 3 Ln(XGCHt) +β 4


Ln(REXRt)
+ β 5 Ln(XGt-1) + β 6 Time
Ln(MGt) = α + β 1 Ln(GDPNt) + β 2 Ln(MGINDt) + β 3 Ln(MGCHt) +β 4
Ln(REXRt)
+ β 5 Ln(MGt-1) + β 6 Time
XGt = Exp(Ln(XGt))
MGt = Exp(Ln(MGt))
GBt = XGt - MGt

Ln (XGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(XGSt-1) + β 4 Time


Ln (MGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(MGSt-1) + β 4 Time

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Nepal Macroeconomic Model- Inception Report

SCRt = XGSt – XGt


SDBt = MGSt – MGt
SBt = SCRt - SDBt

Ln(FICRt) = α + β 1 Ln(GDPNt) + β 2 Ln(FICRt-1) + β 3 Time


Ln(FIDBt) = α + β 1 Ln(GDPNt) + β 2 Ln(FIDBt-1) + β 3 Time
FICRt = Exp(Ln(FICRt))
FIDBt = Exp(Ln(FIDBt))
FIBt = FICRt - FIDBt

GRt = Grants are estimates on the basis of historical growth rates as described in section
8.2.1 adjusted by current information by the government
Ln (TRPt) = α + β 1 Ln(GDPNt) + β 2 Ln(TRPt-1) + β 3 Time
Ln (REMt) = α + β 1 Ln(GDPNt) + β 2 Ln(REMt-1) + β 3 Time
TRBt = GRt + TRPt + REMt

CABt = GBt + SBt + FIBt + TRBt

DISBt and AMORTt are estimated on the basis of projected profile of external public
debt and negotiated terms and conditions for disbursement and repayments of principal.

Ln (FDIt) = α + β 1 Ln(GDPNt) + β 2 Ln(FDIt-1) + β 3 Time


Ln (OINVt) = α + β 1 Ln(GDPNt) + β 2 Ln(OINVt-1) + β 3 Time
PRCAPt = FDIt + OINVt

EBOPt is determined on the basis of past trends.

CAPBt = DISBt –AMORTt + PRCAPt + EBOPt

OBt = CABt +CAPBt

FERt = FERt-1 + OBt

MMt = 12 * FERt / MGSt+1

8.4 Monetary and Financial Sectors

List of variables, their types and notations are indicated in the


following table:

List of Variables Type of Variable Notation


Monetary survey (Billion NR)
Net foreign assets Endogenous NFA
Net domestic assets = DC + OIN Identity NDA
Domestic credits = BCG + BCP + BCF Identity DC
Credits to the public sector, net Endogenous BCG

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Nepal Macroeconomic Model- Inception Report

Credits to the private sector, net Endogenous BCP


Claims on financial institutions Endogenous BCF
Other items, net (OIN) Endogenous OIN
Broad money (M3) demand Identity M3
Broad money (M3) supply = Identity M3
M1+Time Deposits
Quasi Money (M1) = (a) +(b) Identity M1
(a) Currency outside banks Endogenous CUR
(b) Demand Deposits Endogenous DD
Time Deposits Endogenous TD
Interest Rates (% per annum) Endogenous INT
Term deposit rate (one year) TDR
Prime lending rate (medium term) PLR
NRB Bank rate BR

Ln (CURt) = α + β 1 Ln(GDPNt) + β 2 Ln(CURt-1) + β 3 Time


Ln (DDt) = α + β 1 Ln(GDPNt) + β 2 Ln(DDt-1) + β 3 Time
Ln (TDt) = α + β 1 Ln(GDPNt) + β 2 Ln(TDRt-INFt) + β 3 Ln(TDt-1) + β 4 Time
M1t = CURt + DDt
M3t = M1 + TDt

Ln (NFAt) = α + β 1 Ln(OBt) + β 2 Time where OB = overall BOP balance


Ln (BCGt) = α + β 1 Ln(GFDt) + β 2 Ln(BCGt-1) + β 3 Time
Ln (BCPt) = α + β 1 Ln(GFDt) + β 2 Ln(PLRt-INFT) + β 3 Ln(BCPt-1) + β 4 Time
Ln (BCFt) = α + β 1 Ln(DDt) + β 2 Ln(BCFt-1) + β 3 Time
OINt = M3t – NFAt – [BCGt + BCPt + BCPt]
NDAt = BCGt + BCPt + BCPt + OINt
M3t = NFAt + NDAt

8.5 Prices, Interest Rates and Exchange Rates

PLRt = α + β 1 Ln(M3t) + β 2 INFt + β 3 BR + β 4 CRR + β 5 Exchange Rate + β 6


Time
Deposit rate = f(WPI inflation, exchange rate in terms of US$, Bank rate, Time)
Exchange Rate in terms of US$ = f(Overall BOP, Domestic Inflation/ World inflation)
WPI inflation = f(Real GDP growth rate, M3 growth rate, PLR, exchange rate)
CPI inflation = f(Indian CPI inflation)
GDP deflator inflation = f(WPI inflation, real GDP growth rate)

List of Variables for Prices, interest rate, exchange rate

List of Variables Type of Variable Notation


Ave Exchange Rate (NR/US$) Endogenous EXR
GDP at current mp (mn US$) Identity GDPMP$
Percapita GDP current mp (US$) Identity PCGDP$
Consumer (Urban) Price Index (1995/96=100) Identity CPI

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Food Endogenous CPIF


Non-Food Endogenous CPINF
CPI Inflation (Annual % change) Identity INFCPI
Food Endogenous INFCPIF
Non-Food Endogenous INFCPINF
Implicit GDP Deflator Identity INFGDP
Deposit rate (annual in percentage) Exogenous DR
NRB discount rate (annual in percentage) Exogenous BR
Prime lending rate (annual in percentage) Exogenous PLR

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Nepal Macroeconomic Model- Inception Report

9. An Operational Dynamic Stochastic General Equilibrium Model for Nepal

9.1 Basic Characteristics of DSGE Model

In recent decades, academic research has emphasized the development of Dynamic


Stochastic General Equilibrium (DSGE) models, whose basic characteristic is to use
microeconomic foundations for modeling macroeconomic behavior. The model has
several advantages. First, micro foundations allow avoiding Lucas’ critique (1976).
Second, the individual rationality behind the aggregate behavior is useful to analyze the
impact of fiscal and monetary policies on private agents’ expectations. Moreover, rational
expectations differentiate effects between permanent and transitory shocks. Third, the
general equilibrium structure maintains the consistency between flow and stock variables,
such as investment and capital stock, the current account balance and the net foreign
assets reserve, fiscal deficit and the total stock of public debt etc. Fourth, there is recent
empirical evidence showing that DSGE models can have a better forecasting performance
than purely econometric models13.

The main objective of the model is to conduct policy analysis and to forecast major
macroeconomic variables for the immediate future and the medium
term which can be used to prepare the government budget,
macroeconomic plan, monetary program, and to formulate budgetary,
fiscal, monetary and real sector policies by the Ministry of Finance,
Nepal Rastra Bank and the National Planning Commission. The model can
also decompose macroeconomic variables for explaining their fluctuations (shocks), both
in history and forecast. Because of its designs, such as micro-foundations, dynamics,
uncertainty and rational expectations, a potential use of the model is the evaluation of the
impact of fiscal and monetary policy on social welfare (such as inflation, poverty etc.).
Other uses of the model include the estimation of non-observable variables such as the
natural interest rate, the potential output, the real exchange rate equilibrium and the
natural unemployment rate for the Nepalese economy. The main advantage of the model
is its ability to estimate all the variables simultaneously.

For operational purpose, such a model generally considers five major


agents viz. the households, the firms, the financial institutions, the
government with its agencies, and the rest of the world. The behavior
of the economic agents is not only decided by economic theories, but
also is estimated on the basis of historical time series data after
satisfying the standard econometric techniques on specification,
identification, estimation, test and calibration.

As discussed in details in Annex-3.13 in Part-II of this report, the DSGE methodology


attempts to explain macro economic phenomena, such as economic growth and the
effects of monetary and fiscal policies, on the basis of macroeconomic models derived
13
Del Negro, M. F. Schorfheide, F. Smets, and R.Wouters (2006). On the Fit of New Keynesian
Models, Journal of Business of Economic and Statistics.

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Nepal Macroeconomic Model- Inception Report

from microeconomic principles. Unlike traditional macro-econometric forecasting


models, DSGE macroeconomic models are not subject to Lucas critique (Woodford,
2003, p. 11; Tovar, 2008, p. 15).

As the name indicates, DSGE models are dynamic, studying how the economy evolves
over time. They are also stochastic, taking into account the fact that the economy is
affected by random shocks such as technological change, fluctuations in the price of oil,
or errors in macroeconomic policy-making. Traditional macro-econometric forecasting
models used by central banks in the 1970s estimated the dynamic correlations between
prices and quantities in different sectors, and often included hundreds of variables.

Since DSGE models are technically more difficult to solve and analyze, they cannot deal
with sectoral details as given in the previous section, and would include limited number
of variables. DSGE models provide logical consistency and spell out the essential aspects
of the economy viz. preferences of economic agents, technology used for production,
and institutional framework for monetary, fiscal and external sector policies.

The best example of DGSE models include the Smets-Wouters model, developed by the
European Central Bank (ECB), to analyzes the economy of the Eurozone as a whole
(without analyzing individual European countries separately). Another partial DGSE
model is used by the staff of the Joint Committee on Taxation to model the
macroeconomic effects of proposed tax legislation in the United States of America.

With limited database and resources (in terms of technical manpower, hardware and
software requirements, and Finance) and no previous experience of DGSE modeling such
a leapfrogging may not be feasible for Nepal. So we make an attempt to develop a simple
DGSE Model for Nepal. Here we present the basic structure of an operational DSGE
Model for Nepal. The Model will be fully developed in the course of the modeling
exercises by the consultants after examining fully the available data base, estimation
techniques and computer algorithms for test, calibration, projections and simulations.

9.2 Model Specification

The model is a simple macro-econometric one with a combination of


supply and demand factors influencing economic growth. An increase
in aggregate demand leads to increase in output and prices14 which in
turn influence the supply. Output (GDPR) of the economy is determined
by domestic demand (DR) and external demand. As in the case of
NMEM, domestic demand (DR) is determined as sum of private
consumption (CP), government consumption (CG), total investment
(INV) and Stocks (ST). External demand equals exports of goods and
services (XGS) less imports of goods and services (MGS).

As in the case of NMEM described in the previous section, the DSGEM will have five
interrelated blocks as follows. However, unlike in the NMEM, demand equations in this
14

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model will take into account the behavior, preferences and expectations of the economic
agents and the production side will consider technological equations.

(1) National Accounts System (NAS) - Supply and Demand Side


(2) Government Finance (GF)
(3) Balance of Payments (BOP)
(4) Monetary-Financial Sectors (MFS)
(5) Prices, Interest Rates and Exchange Rates

9.3 Data system, estimation procedure and software used in model

The model would use annual time series data for the period from 1985
to 2008 obtained from the CBS, MOF and NRB. The model will be
calibrated and tested by EVIEWS 6.0.

Methods of estimation

A DSGE model comprises a set of equations that jointly describe the


relationship between a set of variables. The equations consist of
simultaneous and single equations and simple identities. There are two
approaches to estimate the model equations. One approach is to
estimate each equation in the system separately. A second approach is
to estimate, simultaneously, the complete set of parameters of the
equations in the system. In reality, single equation estimation method
is easier and more flexible for adjusting and selecting the form of
equation15. There are some advanced techniques to estimate system of
simultaneous equations such as Two Stage Least Squares (TSLS) or
Three Stage Least Squares (3SLS). However these methods are not
only complex but also require large sets of data. An alternative but
simpler technique for estimation is called the Seemingly Unrelated
Model (SUR), which is a recursive model consisting of a series of
endogenous variables as a group. The model estimates the equation
system by transforming it as one combined equation. This increases
the efficiency because there are more degree of freedom to estimate
the parameters for variables than single one.

So we would apply first the ordinary least squares (OLS) method to


estimate the single equations and to identify the form of each
equation. And then we would apply the SUR model for estimating
system of equations.

15
If one of the equations in the system is miss-specified and estimate the parameters
using single equation methods, only the miss-specified equation will be poorly
estimated. If system estimation techniques are employed, the poor estimates for the
misspecification equation may "contaminate" estimates for other equations.

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A common finding in time series regressions is that the residuals are


correlated with their
own lagged values. This serial correlation violates the standard
assumption of classical regression theory that disturbances are not
correlated with other disturbances. In this case, we could apply auto
regressive model (RAM) to correct the serial correlation error. The
simplest and most widely used model of serial correlation is the first-
order autoregressive, or AR(1), model, which stands as follows:

Yt = βXt + Ut (1)
Ut = ρUt-1 + Vt (2)
The parameter ρ is the first-order serial correlation coefficient. In
effect, the AR(1) model
incorporates the residual from the past observation into the regression
model for the current observation. For example, the EVIEWS software
automatically uses the following equation to transform the linear
model into a nonlinear model:

Yt = ρYt-1 + β(Xt – ρXt-1) + Vt (3)

which is obtained by substituting equation (2) into equation (1), and


rearranging terms. The coefficients ρ and β are estimated
simultaneously. EVIEWS software provides the DW test, the Q-statistic
and the Breusch-Godfrey LM test to test the serial correlation16.

9.4 National Accounts


9.4.1 Supply Side

Real GDP at constant factor cost will be projected for the broad sectors
of the economy. List of variables, their types and notations are
indicated in the following table:

List of Variables Type of Variable Notation


A. Population (million, as on 2 July Exogenous POP
Population growth rate (% per annum) Exogenous POPGR
Work force (age 15-65 years) Exogenous WF
Employment (in '000) Exogenous L
Total employment = LAG + LIND + LSER Identity L
Agriculture Exogenous LAG
Industry Exogenous LIND
Services Exogenous LSER
Capital Stock (in million NR) Exogenous K
Total Cap Stock = KAG + KIND + KSER Identity K
Agriculture Exogenous KAG
Industry Exogenous KIND

16
For details consult EVIEW user’s guide book or EVIEW help.

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Services Exogenous KSER


Human Capital (in '000) Exogenous H
Total Human Cap = HAG + HIND + HSER Identity H
Agriculture Exogenous HAG
Industry Exogenous HIND
Services Exogenous HSER
B. GDP: Supply Side
1. GDP const FC (Mill. NR) =1.1+1.2+1.3 Identity GDP
1.1 Agriculture and allied Endogenous GDPAG
1.2 Industry = 1.2.1+1.2.2+1.2.3+1.2.4 Identity GDPIND
1.3 Services = 1.3.1+1.3.2+1.3.3+1.3.4 Identity GDPSER
1. GDP const FC (Mill. NR) =1.1+1.2+1.3 Identity GDP
2. (Plus) Indirect taxes less subsidies Endogenous INDT
3. GDP at cons mp (Mill. NR) = 1 + 2 Identity GDPMP
4. GDP at current mp (Mln NR) Endogenous GDPN
The proposed equations are as follows:

GDPt = GDPAGt + GDPINDt + GDPSERt


GDPAGt = α + β 1 Ln(LAGt) + β 2 Ln(KAGt) + β 3 Ln(HAGt) + β 4 Time
GDPINDt = α + β 1 Ln(LINDt) + β 2 Ln(KINDt) + β 3 Ln(HINDt) + β 4 Time
GDPSERt= α + β 1 Ln(LSERt) + β 2 Ln(KSERt) + β 3 Ln(HSERt) + β 4 Time

Where H stands for human capital indicating skill of the labor force. It is estimated by

H = (5H1 + 8 H2 + 12H3 + 15H4) / N, where


H1 = Primary school pass among the labor force
H2 = Middle school pass among the labor force
H3 = High school pass among the labor force
H4 = College pass (graduates) among the labor force
L = Total labor force in the age group of 15-65 years

9.4.2 Demand Side of GDP

Demand side is projected at current market prices because decisions by economic agents
are always made on the basis of current market prices. List of variables, their types
and notations are indicated in the following table:

GDP at current mp (Mln NR) Identity GDPN


=a+b+c+d+e-f
(a) Private consumption Endogenous CP
(b) Government consumption Endogenous CG
(c) Gross fixed capital formation = (i)+(ii) Endogenous FC
(d) Change in stocks Endogenous ST
(e) Exports of goods and services Endogenous XGS
(f) Imports of goods and services Endogenous MGS
Investment (at current prices)=a+b+c Identity INV
(a) Agriculture and allied Endogenous INVAG

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Nepal Macroeconomic Model- Inception Report

(b) Industry Endogenous INVIND


(c) Services Endogenous INVSER
Other explanatory variables (current prices)
Tax revenues of the government Exogenous TAX
Total revenues of the government Exogenous REV
Time = 1, 2, .. for the years 1984/85, … Exogenous Time
Inflation rare in terms of WPI Exogenous INFWPI
Bank credits to the private sector Exogenous BCP
Bank credits to the public sector Exogenous BCG
Fixed ratio of stocks/ inventories to total Exogenous K
gross fixed capital on the basis of past data
Real exchange rate of Nepalese Rupee in Exogenous REXR
terms of US dollar

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Nominal GDP is determined by the usual balance equation. The other equations are
specified below.

GDPNNt = CPt + CG t + FCt + STt + XGSt – MGSt

Private consumption (CP) will be estimated by the following relation by pooling both
time series and cross section data:

Ln(CPt) = α + β 1 Ln(Yt) + β 2 Ln(WPIt) + β 3 Time

β 1 is the Engel (income) elasticity whereas β 2 is the price elasticity of private


consumption demand. If household expenditure data classified by income groups are
available, then different Engel curves of the following forms will be fitted on the basis of
cross section data obtained from the latest household expenditure survey. The best fitted
Engel curve as judged by the goodness of fit statistics will be used to estimate the Engel
elasticity (β 1).

Linear C = α + β Y
Log linear Log C = α + β Log Y
Semi log Log C = α + β Y
Log Inverse Log C = α + β /Y
Log Log Inverse Log C = α + β 1 Log Y+ β 2 / Y

This Engel elasticity will be taken as given to estimate price elaticity (β 2) on the basis of
time series data.

As in the NMEM, government expenditure will be determined on the basis of the


following equation.

Ln(CGt) = α + β 1 Ln(REVt) + β 2 Ln(GDPNt) + β 3 Ln(CGt-1) + β 4 Time

For fixed investment, we will use the traditional lagged investment model. Using
incremental capital/output ratio (h), gross investment is given by

INVt = α + h (GDPt – GDPt-1) + δ Kt-1

Where K is the capital stock and δ is the rate of depreciation of capital.

Following Koyck’s model on adopted expectations, we get

INVt = α + h (1-λ ) GDPt + (λ -1) Kt-1

Exports and imports of goods and services will be estimated by the same equations as in
the NMEM model:

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Ln (XGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(XGSt-1) + β 4 Time


Ln (MGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(MGSt-1) + β 4 Time

Finally stocks and inventories will be taken as a residual to maintain equilibrium in the
supply and demand sides of GDP.

STt = GDPNt – [CPt + CG t + FCt + XGSt – MGSt]

Where GDPNt is the GDP at current market prices obtained from the supply side.

9.5 Government Finance Block

List of variables, their types and notations are indicated in the


following table:

Central Govt Operations (Billion NR)


1.Total Revenue and grants = 1.1+1.2 Identity TRG
1.1 Total revenue = (a) + (b) Identity R
1.2 Grants Exogenous GR
2. Total Expenditure & net lending = 2.1+2.2 Identity GEXP
2.1 Current expenditure = (a) + (b) Endogenous CG
(a) Interest payments Endogenous INT
2.2 Capital expenditure and net lending = a+b Identity GK
(a) Capital expenditure Endogenous FCG
(b) Net lending Endogenous ND
3. Current A/C Balance =1.1 - 2.1 (a) Identity CABGF
4. Gross Fiscal Balance = 1-2 Identity GFB
5. Primary Balance = 4 - Interest payments Identity PB

The proposed equations stand as follow:

Ln(Rt) = α + β 1 Ln(GDPNt) + β 2 Ln(Rt-1) + β 3 Time


Ln(GRt) = α + β 1 Ln(GDPNt) + β 2 Ln(GFBt) + β 3 Ln(GRt-1) + β 4 Time
Ln(CGt) = α + β 1 Ln(REVt) + β 2 Ln(GDPNt) + β 3 Ln(CGt-1) + β 4 Time

INT = Interest payments are estimated on the basis of projected profile of domestic and
external public debt and negotiated terms and conditions for interest payments

Ln(FCGt) = α + β 1 Ln(REVt) + β 2 Ln(GDPNt) + β 3 Ln(FCGt-1) + β 4 Time

Ln(NDt) = α + β 1 Ln(Rt) + β 2 Ln(GDPNt) + β 3 Ln(NDt-1) + β 4 Time


GEXP = CG + FCG
CABGF = Current account balance in government finance = TRG-CG
GFB = TRG- GEXP
PB = GFD-IINT

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Nepal Macroeconomic Model- Inception Report

9.6 Balance of Payments Block

List of variables, their types and notations are indicated in the


following table:

Balance of Payments (Million US$) Type of Variables Notation


Goods balance = XG-MG Identity GB
Exports of goods f.o.b.=XGIND+XGCH+XGR Endogenous XG
Imports of goods c.i.f.=MGIND+MGCH+MGR Identity MG
Non-factor services balance = SCR-SCDB Identity SB
(a) Credits Endogenous SCR
(b) Debits Endogenous SDB
Factor incomes balance = FICR-FIDB Identity FIB
(a) Credits Endogenous FICR
(b) Debits Endogenous FIDB
Transfers Balance = (a)+(b)+(c) Identity TRB
(a) Official grants, net Exogenous GR
(b) Private, net Endogenous TRP
(c) Remittances Endogenous REM
Current account balance Identity CAB
(CAB)=GB+SB+FIB+TRB
Exports of goods & services Identity XGS
Imports of goods & services Identity MGS
Capital and financial account
Official loans, net = DISB-AMORT Identity DISB-AMORT
Disbursement Exogenous DISB
Amortization (AMORT) Exogenous AMORT
Private capital inflow Identity PRCAP
FDI, net Endogenous FDI
Other investment, net Endogenous OINV
Errors and omissions Endogenous EBOP
Capital and Financial Balance Identity CAPB
Overall balance = OB Identity CAB+CAPB
Foreign Exch reserve at the end period Identity FER
Equivalent to months of imports Identity MM

Merchandise exports and imports of Nepal will be estimated on the basis of gravity
model on international trade:

Exports (XG) of Nepal = f(GDP of Nepal, GDP of major trading partners, total imports
of major trading partners, average shipping cost to major trading partners, export price,
exchange rate of Nepalese rupee in terms of dollar)

Imports (MG) of Nepal = f(GDP of Nepal, GDP of major trading partners, total exports
of major trading partners, average shipping cost from major trading partners, import
price, exchange rate of Nepalese rupee in terms of dollar)

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Nepal Macroeconomic Model- Inception Report

Ln (XGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(XGSt-1) + β 4 Time


Ln (MGSt) = α + β 1 Ln(GDPNt) + β 2 Ln(REXRt) + β 3 Ln(MGSt-1) + β 4 Time

SCRt = XGSt – XGt


SDBt = MGSt – MGt
SBt = SCRt - SDBt

Ln(FICRt) = α + β 1 Ln(GDPNt) + β 2 Ln(FICRt-1) + β 3 Time


Ln(FIDBt) = α + β 1 Ln(GDPNt) + β 2 Ln(FIDBt-1) + β 3 Time
FICRt = Exp(Ln(FICRt))
FIDBt = Exp(Ln(FIDBt))
FIBt = FICRt - FIDBt

Ln(GRt) = α + β 1 Ln(GDPNt) + β 2 Ln(GFBt) + β 3 Ln(GRt-1) + β 4 Time


Ln (TRPt) = α + β 1 Ln(GDPNt) + β 2 Ln(TRPt-1) + β 3 Time
Ln (REMt) = α + β 1 Ln(GDPNt) + β 2 Ln(REMt-1) + β 3 Time
TRBt = GRt + TRPt + REMt

CABt = GBt + SBt + FIBt + TRBt

DISBt and AMORTt are estimated on the basis of projected profile of external public
debt and negotiated terms and conditions for disbursement and repayments of principal.

Ln (FDIt) = α + β 1 Ln(GDPNt) + β 2 Ln(FDIt-1) + β 3 Time


Ln (OINVt) = α + β 1 Ln(GDPNt) + β 2 Ln(OINVt-1) + β 3 Time
PRCAPt = FDIt + OINVt

EBOPt is determined on the basis of past trends.

CAPBt = DISBt –AMORTt + PRCAPt + EBOPt

OBt = CABt +CAPBt

FERt = FERt-1 + OBt

MMt = 12 * FERt / MGSt+1

9.7 Monetary and Financial Sectors


9.8 Prices, Interest Rates and Exchange Rates

These two sub-models will be the same as in the NMEM.

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Nepal Macroeconomic Model- Inception Report

10. Recommendation on the Choice of Hardware and Software


Required for Nepal Macro Economic Modeling Works

10.1 Objectives of the Project

As mentioned earlier, the major objectives of the ADB TA project are to upgrade the
existing previously developed Nepal Macroeconomic Model (NMEM) and develop a
Dynamic Stochastic General Equilibrium Model (GSGEM) and to improve the capacity
of the concerned stakeholders (especially, NRB, MOF, NPC, CBS and Nepalese
Universities mainly Tribhuvan University) by providing them training on updating the
NMEM and developing using the specified software. Both of these activities need the
specific hardware and software requirements which need to be provided to the
implementing agencies. In this regard, the TA team has intensively explored for selecting
the right one among the available options.

Software Requirement

The software requirement has been explored under two criteria. Firstly, the TA team
needs to select the best econometric software having the capacity of calibrating the pre-
defined econometric models. Secondly, the TA team needs to select the user friendly’s
visual display software having capacity to run simulation exercise (especially policy
shock) in the model without using the econometric software’s command. This second
requirement also includes the selection of appropriate database software in which all the
data required by the model will be stored.

Recommended Software – Eviews

That software - EViews17 (EViews version 6, hereafter will be called only EViews),
which is very user friendly, easy for data transformation/crunching, fast enough for
running several equations, robust for programming and using data from different
platforms, has been selected by the team for achieving the objective of the project be used
through studying the major features of the software – Eviews and comparing mostly used
econometric and statistical Software. Detailed features of Eviews 6 are presented in
Annex-8. Here we summarize the basic features of Eviews 6.

System Requirement for the Software – Eviews

EViews 6 is compatible with most versions of the Windows Operating system including:
Windows 98/Me/NT 4.0/2000/XP/Vista. It can tackle problems involving up to 15
millions of observations or thousands of series. It takes full advantage of 32-bit
Windows’ virtual memory, so that it can work with data sets that exceed system’s

17
Quantitative Micro Software (QMS) has been a leading developer of statistical software for microcomputers for over
two decades. Its first product was the popular MicroTSP software used for model simulation and forecasting. MicroTSP
was replaced by the Windows-based EViews in 1994.

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Nepal Macroeconomic Model- Inception Report

physical memory, subject to operating system restrictions on the total amount of memory,
up to 3GB with Windows XP and Vista.

10.2 Major Features of the Software - EViews


10.2.1 Database and Data Handling Capacity

EViews Database: It provides sophisticated built-in database features. It is a collection


of EViews objects maintained in a single file on disk. It need not be loaded into memory
in order to access an object inside it, and the objects in the database are not restricted to
being of a single frequency or range. It offers powerful query features which can be used
to search through the database for a particular series or select a set of series with a
common property. Series contained in it may be copied (fetched) into a workfile, or they
may be accessed and used by EViews procedures without being fetched into workfiles. In
both cases, EViews will automatically perform frequency conversion if necessary.
Automatic search capabilities allow you to specify a list of databases to be searched when
a series you need cannot be found in the current workfile.

Data Handling and Crunching: The NMEM project consists of complex data type
including regular and irregular dated data, cross-section data with observation, and time-
series data. EViews can proficiently handle such complex data structures. It also provides
a wide range of tools for working with data sets (workfiles) including the ability to
combine series by complex match merge criteria and workfile procedures for changing
the structure of data by joining, appending and taking subset, resize, sort, and reshape.

Dynamic Object Updating: EViews incorporates the best of modern spreadsheet and
relational database technology into tools for performing the traditional tasks of statistical
software. The EViews object-based approach includes sophisticated linking technology
that allows defining relationships between multiple objects and external data sources.
Series objects, for example, may be linked by formula to data in other series, to match
merged or frequency converted data from alternate data sets, or to data from external
databases. When defined in this fashion, the linked series dynamically updates its data
whenever the underlying data change. Similarly, an EViews model simulation object can
be linked to equation or system objects so that the model specification updates
automatically when the underlying equation or system is re-specified or re-estimated.
These object updating features are the most useful feature of NMEM project as the model
is expected to be updated very frequently in future.

Import and Export Capacity: EViews can exchange data with other programs very
easily. It can reads and writes over 20 popular data formats including Excel, formatted
and unformatted ASCII/Text, SPSS, SAS (transport), Stata, SPSS, Html, Microsoft
Access, Gauss Dataset, Rats, GiveWin/PC Give, TSP, Aremos, dBase, Lotus, and binary
files. Importing of data to EViews platform is so easy and only drag-and-drop from
foreign file onto can create the EViews workfile. There are dialog and wizards to
customize the importing in easy-to-use way.

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Nepal Macroeconomic Model- Inception Report

Data Handling Capacity: The number of observations and variables which EViews can
handle is practically unlimited. The physical capacity is specified as following:

Specifications Requirements
Maximum observations per series 4 million (by default), may be increased if
desired, subject to memory restrictions
Total observations: (series x obs per series) limited only by available RAM
Maximum objects per workfile limited only by available RAM
Maximum objects per database limited to 1 million objects, 2 gigabytes or
available disk space

10.2.2 Working Environment

Multiple Window Display: EViews allows for simultaneous display of multiple objects,
each in its own window. This true multiple window support makes it easy to perform
side-by-side comparisons of series plots, hypothesis tests, equation estimates, or model
forecasts developed under alternative assumptions.

Command Line Programming and Program Interface: NMEM needs complex


programming to operational zed so that the point-and-click mode of operation will not be
appropriate for it rather programming in text files will be needed so that the whole
program can be modified and verified as per needed and can be saved in files. EViews
has a powerful command language that provides access to all of the features that are
available through the menus.

EViews allows you to enter individual commands for immediate or batch execution and
allows use of looping and condition branching, as well as subroutine and macro
processing. It also allows matrix primitives, from simple multiplication and inversion, to
more advanced procedures for Kronecker products, eigenvector solution, and singular
value decomposition with the tools for solving complex mathematical problems like
linear and dynamic programming.

10.2.3 Tools for Data Analysis

Basic Analysis Tools: EViews supports a wide range of basic statistical analyses, from
simple descriptive statistics to parametric and nonparametric hypothesis tests including
testing against specific values, testing for equality between series, or testing for equality
within a single series when classified by other variables. Tools for covariance and factor
analysis allow you to examine the relationships between variables.

Special Tools for Time-Series Analysis: EViews standout among other competitor
software in the tools for sophisticated and diverse tests for time-series data ranging from
simple autocorrelation plots to frequency filters, from Q-statistics to unit root tests in a
very simplified way. It can provide autocorrelation and partial autocorrelation functions,
Q-statistics, and cross-correlation functions, unit root tests (ADF, Phillips-Perron, KPSS,

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Nepal Macroeconomic Model- Inception Report

DFGLS, ERS, or Ng-Perron for single time series and Levin-Lin-Chu, Breitung, Im-
Pesaran-Shin, Fisher, or Hadri for panel data), cointegration tests (Johansen for with
MacKinnon-Haug-Michelis critical values and p-values ordinary data, and Pedroni, Kao,
or Fisher for panel data), causality, and independence tests. EViews computes trends and
circles from time series data using the Hodrick-Prescott filter, Baxter-King, Christiano-
Fitzgerald fixed length and Christiano-Fitzgerald asymmetric full sample band-pass
(frequency) filters.

System Estimation: EViews offers powerful tools for estimating and analyzing both
linear and nonlinear systems of equations by OLS, two-stage least squares, seemingly
unrelated regression, three-stage least squares, GMM, and FIML. The system may
contain cross equation restrictions and in most cases, autoregressive errors of any order.

VAR and VEC Models: Vector Autoregression(VAR) and Vector Error


Correction(VEC) models can be easily estimated by EViews. Once estimated, it can
examine the impulse response functions and variance decompositions for the VAR or
VEC. VAR impulse response functions and decompositions feature standard errors
calculated either analytically or by Monte Carlo methods and may be displayed in a
variety of graphical and tabular formats. For cointegrating relations and/or adjustment
coefficients, EViews' VARs also allows estimating structural factorizations (VARs) by
imposing short-run (Sims 1986) or long-run (Blanchard and Quah 1989) restrictions.
Over-identifying restrictions may be tested using the LR statistic. VARs support a variety
of views allowing testing the structure of the estimated specification. With a few clicks of
the mouse, it can display the inverse roots of the characteristic AR polynomial, perform
Granger causality and joint lag exclusion tests, evaluate various lag length criteria, view
correlograms and autocorrelations, or perform various multivariate residual based
diagnostics.

Forecasting and Simulation for Multiple Equations: EViews can handle multiple
equation forecasting. The EViews can provide the tools for managing, analyzing and
solving large systems of equations. It offers a variety of solution methods, including
stochastic simulation and forward solution for model consistent expectations, as well as
tools for managing alternative solution scenarios and user-specified add factors. It also
allows examining the dependency structure of the endogenous variables and the block
structure of the model equations, to solve simple control problems, and to generate
custom tables and graphs that compare solution results under alternative assumptions.

Diagnostics Tests: Once estimated, EViews makes it easy to perform specification and
diagnostic tests. These tests include Wald tests of linear and nonlinear coefficient
restrictions, likelihood ratio and F-tests for omitted or redundant variables, Lagrange
multiplier tests for serial correlation and ARCH, Breusch-Pagan-Godfrey, Harvey,
Glejser, and White heteroskedasticity tests, Ramsey RESET tests, Quandt-Andrews
breakpoint, and Chow forecast and breakpoint tests.

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Nepal Macroeconomic Model- Inception Report

10.2.4 Data Presentation Mode

High Quality Output:

EViews can produce high quality graphs and tables for publication or inclusion in other
applications and spool object for the compilation of different outputs.

Graphic Presentation:

EViews supports a wide range of basic graph types including line graphs, bar graphs,
filled area graphs, pie charts, scatter diagrams, mixed line-bar graphs, high-low graphs,
scatter-plots, and box-plots. Any number of graphs can be combined in a single graph for
presentation. There are many easy options for editing the graph from symbols, color,
frame, shading, labeling and scaling including logarithmic scaling and dual scale graphs.
Customizing a graph is as simple as modifying or moving graphic elements on the screen.
Using copy-and-paste or by writing the graph to a Windows metafile, or a PostScript,
bitmap, PNG, GIF, or JPEG file these graphs can be transferred into other applications.

Tables:

Extensive table customization tools allow producing presentation quality tables for
inclusion in other programs. An easy-to-use, interactive interface gives control over cell
font face, size, and color, cell background color and borders, merging, and annotation.
The final outputs can be copy-and-paste to another application or save it as an RTF,
HTML, or text file.

Spooling Facility:

EViews offers a new spool object that allow creating collections of various EViews’
output allowing to store multiple tables, graphs, text, and spools. Various management
tools are allowed to add, delete, extract, resize, annotate, hide and edit the objects in the
spool. This spool is useful for organizing results, for example for creating a log of the
results for a project or an EViews session, or perhaps for gathering output for a
presentation.

10.3 Choice of Software

After a quick survey of implementing agencies (mainly, NRB, MOF, NPC), the TA team
finds that they have shown their interest to continue with their existing statistical and
econometric software – Eviews, SPSS and STATA. So, the TA team has selected the best
software among these three software. These software have been evaluated on the basis of
those criteria such as: Data Handling, Data Management, Data Updates, Powerful
Statistical Analytical Tools, Equation Estimation and Forecasting, and Model Simulation,
which are mainly required for macro modeling exercise. The results are summarized in
Table 10.1.

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Nepal Macroeconomic Model- Inception Report

Table 10.1: Comparative Chart of Econometric and Statistical Software

SPSS STATA EViews


Data Handling Good for Cross Good for Cross Good for Time
Section Data but Section as well as Series Data
time consuming for for Time Series and
Time Series and Panel Data
Panel Data

Data Management Facilities to migrate Facilities to migrate Facilities to migrate


and Data Data to other Data to other Data to other
Warehousing database software database software database software
viz. MS-Excel, MS- viz. MS-Excel, MS- viz. MS-Excel, MS-
Access Access Access

Data Updating User Friendly Data Updates though User Friendly Data
Updating system sheet and has risk of Updating system
using combo box omission and using combo box
repetition

Powerful Statistical Good for Cross Good for Cross Good for Time
Analytical Tools Section Data but Section as well as Series Data and uses
time consuming for time series and practical methods
process for Time Panel data, but the generally used in
Series and Panel methods used are government
Data highly technical and departments and
complex, good for central banks.
academic purpose.

Equation Good for Cross Good for Cross Good for Time
Estimation, test, Section Data but Section as well as Series Data and
calibration and time consuming for for time series data practical for
Forecasting Time Series data but the methods professional users in
used are highly the government
complex, academic departments and
and technical. central banks.

Model Simulation Time Consuming to Lengthy so only Quick and can be


Conduct Model feasible for conducted in various
Simulation academic purpose modes depending on
size of model.

(Source: Prepared by TA team on the basis of inputs available on the respective websites
of the concerned software)

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Nepal Macroeconomic Model- Inception Report

It is evidenced from Table-10.1 that the Eviews is the ideal software for macroeconomic
modeling exercises as it uses very powerful statistical techniques for time series data
management and analysis; equation estimation, test and calibration; forecasting of time
series data and model simulation. Regarding other two, SPSS is suitable for cross section
data and simple statistical analysis. STATA is suitable for sophisticated statistical
analysis and testing and is generally used by the academic institutes.

10.4 Recommendation

In the light of above discussion, the TA team will recommend the purchase of the latest
version (i.e. Eviews Version 6) of Eviews software license from its vendor Quantitative
Micro Software (QMS). The TA team advises to purchase the 10 licensing of Eviews
with 2 being stationed with ADB TA Modeling team, 6 being installed at various
departments of the implementing agency (i.e. NRB) dealing with data management, data
analysis and econometric modeling; and the rest (2) being distributed to the associated
implementing agencies, viz. the Ministry of Finance, the National Planning Commission
and other agency, if any. Specifically, Nepal Rastra Bank, being the main implementing
agencies of the TA, should receive the highest number of licenses. As CBS is implanting
another TA on Quarterly Estimates of National Accounts and have separate budget for
hardware and software, the estimated number of software in this report does not take into
account the hardware and software requirements by CBS.

Estimate of Software Cost for the 10 licenses of Eviews with User’s Guide is as follow:
Table 10.2: Cost Estimates Eviews License for 20 Concurrent Use
Details Amount (USD)##
10 Single Seat Use License Pack 12750
Complete Set of Eview’s User Guide (4set*150)# 600
Total 13350
Notes: # One set each set will be provided to Nepal Rastra Bank, Central Bureau of Statistics, National
Planning Commission and ADB- NRM. The other agencies and institution can print the user’s guides
provided in PDF version along with Eviews Installation CD. ## Eviews website available at
http://www.eviews.com reports that the price may subjected to change without prior notice so consider the
price in 10% margin.). (Source: http://www.eviews.com )

Operating System: Eviews-6 is compatible with most versions of the Windows


Operating system including: Windows 98/Me/NT 4.0/2000/XP/Vista. In light of 32-bit
Windows’ virtual memory, the data sets that exceed the system’s physical memory,
subject to operating system restrictions on the total amount of memory, up to 3GB with
Windows XP and Vista.

The Eviews also provides the facility to purchase Computer Lab Licenses in which a
single license for lab can provide Eviews access to multiple computer of the lab stationed
at one place. However, this option is not feasible for this TA purpose because the
executing agencies of this TA are spread in different places.

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Nepal Macroeconomic Model- Inception Report

Visual Display Software: A teller based visual display software needs to be designed in
order to make the macro model user friendly to high class policy makers, bureaucrats,
economists and other stakeholders. This software will access the results of macro model
exercise to the user without using Eviews command so that busy high level personal can
also used our model in their various assignment without devoting their valuable time to
learn Eviews command. This software needs to be compatible with operating system of
Windows XP, 2000, Vista and higher. The local software company can provide us this
teller made software at the cost of around USD 2500 to 2800. (Please Note: The estimated
cost is based on the TA member’s experience with similar type of software).

Hardware Requirement: The hardware capacity which can operate the above
mentioned software need to be provided to all implementation agencies. During the visit
to the concern implementing agencies, the TA team finds that the official of
implementing agencies are provided with the computer that can operate the operating
system required by Eviews i.e. Windows XP, 2000, Vista and higher. But, most of these
computers are operated for daily work purpose so these computers have the problem of
hard disk memory and process’s memory so it won’t be compatible to install the licensed
Eviews in such computer as there is high chance of slow operation of Eviews and other
required software. The computer often gets hang when the complex simulation are run in
the Eviews. It has also been observed that the relevant department of Nepal Rastra Bank
that provide the data for modeling exercise are less equipped with the accessories
equipments like printer and photocopy machine. These equipments are required to have
hardcopy of data for its proper review before injecting to model and for inter agencies
communication to revise the model. In this background, the TA team purpose to provide
the following equipments to concern agencies.

Desktop Computer: The desktop computers equal to the number of license of Eviews
need to be provided to all agencies other than ADB- NRM and TA team. So the required
number of the desktop computers will be 14 which will be distributed as per Eviews
license to concern agencies. The minimum required specification for the desktop
computer in order to operate Eviews is as follow:

Intel® Pentium® Dual-Core Processor E2220 (1MB L2 cache, 2.40GHz,


800MHz FSB)
4GB (2/2) DDR2 SDRAM
300GB SATA Hard Drive (At Least)
Two USB 2.0 (At Least)
1 eSATA port
Variable-speed Super-Multi drive
NVIDIA® GeForce® G100 graphics
VGA, HDMI, DVI, headphones, microphone and five audio ports
Gigabit LAN
V.92 Modem
Genuine Windows Vista Home Premium 64-bit version
Power Supply 220 watts

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Nepal Macroeconomic Model- Inception Report

The cost for the desktop computer depends on its brand. Basically, the most available
brands in Nepal cost between USD 535 to 935. There is so wide deviation between prices
because some brands also provide the licensed operating system whose costs are also
included in the computer’s price.

Printer: As discussed earlier on the limited accessories equipment in the concerned


Departments of NRB, the TA team also advises to provide two printers of medium
capacity to the concern department of Nepal Rastra Bank. The specification of printer
machine is as follow:

Laser Print
12 pages per minute (A4 size and letter)
600 X600 dpi resolution
Uses PC memory (Standard 2MB on-board)
USB 2.0 Hi-Speed
A4, B5, A5, LGL,LTR, Executive Envelope
Face down: 100 sheets
220-240 V (+/-10%),50/60Hz (+/-2Hz)
Windows 98/ME/2000/XP, Linux (CUPS)

The cost for the printer depends on its brand. Basically, the most available brands in
Nepal cost between USD 170 to 250.

Budget for the Software and Hardware:

The tentative budget for the procurement of recommended hardware and software is
provided in Table-10.3. The cost for hardware component is provided in range because
the price of hardware is as per the brand. Further, there might be some changes on the
price without pre notice so the budget should be consider in 10 percent range of price (i.e.
Price might increase or decrease by 10 percent)

Table 10.3: Budget for the Software and Hardware*


Details Amount (in USD)
5 Single User’s License of Eviews (to be installed 6375
in 15 computers) 1275 * 5
4 Complete set of Eviews User Guide 600
Visual Display Software 2500 – 2800
8 Desktop Computer ( 535*8 – 935*8) 4280-7480
1 Photocopy Machine (1800*1 – 2000*1) 1800 – 2000
2 Printer (170*2 – 250*2) 340 – 500
Total 15875-19750
(Source: Collected by TA Team from Market)
(* The price might fluctuate in 10 percent range)

Time Table

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Nepal Macroeconomic Model- Inception Report

The TA requests to provide the required software and hardware to the concern agencies
earliest by possible tentatively in the early days of TA’s second phase (i.e. 1 st Week of
January, 2010) so that modeling exercise is smoothly implemented.

Selected References

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The Economic Journal, 105, July, pp. 1001-1013.

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Nepal Macroeconomic Model- Inception Report

Das, Tarun (2006) Macroeconomic Situation and Management of External Debt in


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Hoover). Dordrecht: Kluwer Academic Press (Forthcoming).

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Fabio Canova (2007) Methods for Applied Macroeconomic Research, Princeton


University Press, ISBN 0-691-11504-4.

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