Essays on the exchange rate and monetary policy in Nepal

Nepal has a large and growing trade deficit with India and an overall negative trade balance. Its economy is growing slowly relative to India's, while the exchange rate is pegged with India at a parity that is believed to be overvalued. India is Nepal's largest trading partner, with which it also shares an open order. The peg is considered central to macroeconomic stability and is treated as the monetary policy anchor. Nepal also represents a typical case of a country in which remittances are vital for short-run macroeconomic stability, while they may have adverse consequences for the long-run health of the economy. The three essays in this dissertation are relevant to a broader discussion on the macroeconomic impact of remittances in the context of a low-income country.In the first chapter, I consider possible misalignment of Nepal's real effective exchange rate by estimating a behavioral equilibrium exchange rate using a set of fundamentals for the period 1975--2008. The estimates from the Johansen (1998) cointegrated-VAR model as well as a single equation bounds-testing approach to cointegration suggest that Nepal's trade-weighted real exchange rate was overvalued in the last decade and a half.The question of the efficacy of monetary policy in influencing the exchange rate is analyzed in the second chapter, using a monetary model of exchange market pressure. Applying a recently developed estimation technique, impulse indicator saturation, along with general-to-specific modeling, I find that a contractionary monetary policy results in easing pressure on the exchange rate. The robustness of the results is confirmed using various tests.The final essay entails a comprehensive analysis of economic symmetry between Nepal and India, which is one of the pre-conditions for monetary integration. A two-pronged empirical investigation reveals inconclusive evidence to justify such integration on economic grounds. First, using a three-variable SVAR showed a low and negative correlation in the supply shocks. Decomposing the structural shocks into regional and idiosyncratic components showed a favorable co-movement with the regional element only in Nepal's monetary shock. Second, the business-cycle analysis using state-space models of GDP and its components showed some evidence of co-movement with the regional element in some variables while others showed divergence.