Tarun Das ADB Nepal Inception Report Final-Annex

Nepal Macroeconomic Model- Inception Report
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INCEPTION REPORT (FINAL):

NEPAL MACROECONOMIC MODEL (NMEM) AND
DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM (DSGE) MODEL-
MODEL STRUCTURES, DATA BASE, AND SOFTWARE-HARDWARE REQUIREMENTS
PART-II ANNEX
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
12 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, and
Focal Officer, Technical Committee on Modeling, 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)
1
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
2
PART-II: ANNEX
Table of Contents
ANNEX-1: ECONOMIC CONTEXT OF MODELING 4-13
ANNEX-2: BUILDING UP OF AN OPERATIONAL MACROECONOMIC MODEL 14-17

FOR NEPAL
ANNEX-3: SCOPE, CHARACTERISTICS AND TYPES OF MACROECONOMIC 18-32
MODELS
3.1 SCOPE OF MODELING AND FORECASTING 18
3.2 FACTORS AFFECTING MODELING 18
3.3 TYPES OF MODELS 19
3.4 DESIRABLE CHARACTERISTICS OF AN IDEAL MODEL 19
3.5 VARIOUS OPERATIONAL MACROECONOMIC MODELS 20
3.6 MACROECONOMIC MODEL IN LEONTIEF I-O FRAMEWORK 21
3.7 SOCIAL ACCOUNTING MATRIX & GENERAL EQUILIBRIUM 22
3.8 LINEAR PROGRAMMING AND GRAVITY MODEL 22
3.9 ECONOMETRIC MODELS 23
3.10 STRUCTURAL MACROECONOMETRIC MODELS 25
3.11 VECTOR AUTOREGRESSIVE MODEL (VAR) 27
3.12 GENERAL EQUILIBRIUM MODEL 28
3.13 DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM MODEL 29
ANNEX-4: DATA BASE REQUIRED FOR TEST AND CALIBRATIONS OF THE 33-37
NMEM AND DSGE-TYPE MODELS FOR NEPAL
ANNEX-5: TERMS OF REFERENCE OF THE CONSULTANTS 38-39
ANNEX-6: BRIEF CV OF THE CONSULTANTS 40-43

6.1 INTERNATIONAL MACROECONOMIC MODELING SPECIALIST 40
6.2 NATIONAL MACROECONOMIC MODELING SPECIALIST 41
6.3 NATIONAL ECONOMETRICIAN 42
6.4 NATIONAL IT SPECIALIST 43
ANNEX-7: WORK PLAN MATRIX OF CONSULTANTS 44-48

7.1 INTERNATIONAL MACROECONOMIC MODELING SPECIALIST 44
7.2 NATIONAL MACROECONOMIC MODELING SPECIALIST 46
7.3 WORK PLAN MATRIX OF THE ECONOMETRICIAN 47
7.4 WORK PLAN MATRIX OF THE IT SPECIALIST 48
ANNEX-8A: BROAD FEATURES OF E-VIEWS 6 SOFTWARE 49-52

ANNEX-8B: EVIEWS COMMERCIAL AND GOVERNMENT VOLUME 53-54
LICENSING CONDITIONS AND PRICES
ANNEX-9: LIST OF OFFICERS CONSULTED 55
3
Annex-1
Economic Context of Modeling
1.1 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-1.1). 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.
4
Table-1.1 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.
5
1.2 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-1.2, 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-1.2: 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.
1.3 Recent Economic Development in Nepal

(a) 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,
7
Table-1.3: Recent Trends of Major Economic Indicators of Nepal
8
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.
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.
(b) 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.
9
The strategies of the Plan include the following:
• To give special emphasis to relief, reconstruction and reintegration:

• Creation and expansion of employment opportunities.
• 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.
(c) Social Development Indicators and MDGs
Despite politically difficult situation, trends of many poverty and socio-economic

indicators in the 10th Plan period were encouraging Table-1.4. 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.
10
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).
Table-1.4 Nepal: Social Development Indicators
11
1.4 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-1.5 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.
1.5 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.
12
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.
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Annex-2
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”.
2.1 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?
14
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?
2.2 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
15
(vi) Dynamic Stochastic General Equilibrium (DSGE) Model
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.
2.3 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.
16
(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.
(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.
17
Annex-3
Scope, Characteristics and Types of Macroeconomic Models
3.1 Scope of Modeling and Forecasting
It is well known that a model, (like a model for a house, automobile, aircraft etc.), is an
approximation of reality and contains basic and selected features, and not the exact or all
features of the real world. A macroeconomic model consists of a set of mathematical,
statistical and econometric equations indicating best possible underlying inter-
relationships among major macroeconomic variables such as GDP, consumption, savings,
investment, external trade and capital flows, government revenues and expenditure,
money supply, inflation, interest and exchange rates etc. Macroeconomic modeling and
projections form the basic foundations of the government budgeting, national planning
and monetary programming. These are essential to formulate appropriate public policies
and decisions on budgeting, investment, employment, physical, financial and monetary
planning for achieving sustained growth with poverty reduction and achievement of
MDGs.
Basic building blocks of any economic modeling are the empirical trends of major
macroeconomic variables and estimation of best fitted interrelations among these
variables. However, they are subject to identification and specification problems and are
based on a number of presumptions. First, there is the assumption that the behavior of
economic variables is the joint result of a number of economic variables influencing each
other. Second, although the model is a simplification of complexities of reality, it
captures the crucial features of the economic sectors or systems being studied by us.
Third is the hope that the underlying relations will continue to hold good in future unless
appropriate policies are taken or there are unforeseen internal or external shocks to
change the system.
3.2 Factors affecting modeling
Before building an economic model, we need to take decisions on a number of factors

such as the basic purpose, dimensions and data base of the model, such as the following:
(a) What are the basic objectives of modeling and forecasts? Who are going to use
these and for what purpose?
(b) Planning and forecasting horizon- it could be short term (for one year), or
medium term (for five years) or for the long term (usually ten to fifteen years).
(c) Sectoral disaggregation- what are the broad sectors of the real economy? What
are the broad categories of government taxes and expenditure or the broad items
of the balance of payments we would like to forecast? Actual disagregation
depends on the availability of data and the resources (in terms of skilled
manpower, time, money and computer capabilities in terms of hardware and
software) available at the disposal of the modeling team.
18
(d) Regional disagregation- For consistency, macroeconomic modeling may be

supplemented by regional models for selected variables such as production,
investment and employment for regional planning and budgeting. This again
calls for suitable regional demarcation such as Meso (Middle) level (states and
provinces), Micro (unit) level (villages, towns), sectoral (rural, urban) etc.
(e) Data base – Generally we need past data on the selected variables for at least
twenty years.
(f) Environment- For the short term we may assume no change in technology and
institutional set up. But for the medium and long term we need to have clear
perception and vision about the changes in technology, productivity and
improved governance and institutional set-up.
3.3 Types of Models
There are various types of macroeconomic Models as indicated bellow:
a) Static (at a particular time period, say for a year) and dynamic (takes care of
change of time and business environment). In dynamic model, time is specifically
introduced as an important variable influencing basic macroeconomic variables
and their interrelations.
b) Consistent (shows consistency among the systems equations), behavioral
(depends on the behavior of economic agents) and optimizing (maximizing gains
such as revenue, social welfare, employment etc; or minimizing losses such as
government deficit, BOP deficit, inflation, poverty, inequality etc.).
c) Partial equilibrium (deals with specific sectors) or general equilibrium
(considers equilibrium in the whole system).
d) Sectoral model (deals with a sector such as energy, transport) or the economy-
wide model (deals with all sectors).
e) Spatial model (over space) or regional model (over regions) such as a transport
model
f) Inter-temporal (over time) – multi-year dynamic models are called inter-temporal
model.
g) Intergenerational models – Models dealing with more than one generation usually
spanning over sufficiently long period such as 25 to 40 years.
h) Closed model (which does not consider external trade) and open model (which
deals with both internal and external sectors and their Interlinkages)
19
3.4 Desirable characteristics of an Ideal Model

:
An ideal model needs to have some desirable characteristics such as the following:
(a) Internal consistency- There should not be any inherent contradictions in the
underlying equations of a model
(b) Comprehensiveness with two-way feed backs- As far as possible, a model
should capture the feedbacks to the model.
(c) A model should be dynamic to take care of changes over time.
(d) A model should lead to unique and stable solutions.
(e) A model should be easily specified, identified, estimated, tested and
calibrated with the help of available data, computer capacities, simple algorithms, and
simple statistical and econometric techniques.
(f) Model should be continually tested, calibrated, monitored, reviewed, updated,
simulated and improved to make it more realistic over time.
3.5 Various Operational Macroeconomic Models
Depending on the purpose and availability of data and resources, alternative

macroeconomic models as indicated below can be developed:
(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
20
3.6 Macro-economic Model in Leontief Input-Output Framework
The basic macroeconomic model in Leontief Input-Output Framework consisting of n

sectors stands as the following:
Di= Xi= Σ aij Xj +Fi ∀i=1,2,3 …………….n
Fi = Ci + Gi + Ii + STi + EXPi – IMPi ∀i=1, 2,3 …………….n
Where
Di = Gross Demand for i-th good
Xi = Gross output of i-th good
aij = Leontief input-output coefficient = Amount of i-th good required for
production of one unit of the j-th good.
Fi = Final demand for i-th good
Ci = Private consumption for i-th good
Gi = Public consumption for i-th good
Ii = Investment for i-th good
STi = Stocks/ inventories for i-th good
EXPi = Exports of i-th good
IMPi = Imports of i-th good,
The Model uses the concept of End-Use where total demand is decomposed into
intermediate demand (Σ aij Xj) and final demand (Fi). Intermediate demand is used up
in the process of production and so does not enter into GDP, whereas final demand
creates value addition and is considered for estimation of GDP. Different methods are
used to estimate separate components. Generally, private consumption is estimated by
fitting Engel curves on the basis of consumer expenditure surveys. Various forms of
Engel curves (such as linear, log-linear, semi logarithmic, exponential, log-inverse, log-
log-inverse etc) can be tried and the best fitted form can be used for projection.
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
Public consumption is estimated by the social welfare programs. Investments is estimated

by a distributed lag model by linking investment and output with successively
diminishing .effects over time. Stocks and inventories are estimated with fixed
coefficients on the basis of past trends. Exports and imports are estimated by appropriate
econometric equations or by gravity models on international trade.
Above discussions indicate that the needs for data and resources to develop a Leontief
model are huge. Even India, which has prepared detailed input-output tables and had
been using the Leontief input-output model for planning for more than four decades, is
now discarding the model because it has become non-operational in the context of
ongoing globalization and economic reforms. The application of the Leontief Input-
Output model requires preparation of a reliable technology matrix and its updating from
21
time to time. Given the extent of liberalization, privatization and globalization in almost
all countries of the world leading to liberal technology transfer, the technology matrix is
changing at a fast speed. Consequently, the Leontief input-output model has become
outdated and is hardly used by any country for planning.
3.7 Social Accounting Matrix and General Equilibrium Model
General equilibrium model can also be built up in the social accounting framework. Given
the increasing importance of environmental sustainability over time, there is a tendency
to develop social accounting matrices by the developed countries and some of the
developing nations like India and Bangladesh. But, such attempts are more effective only
when the basic National Accounts Statistics have been fully developed. For a country like
Nepal, which is presently engaged in preparing quarterly estimates of national accounts
statistics, it may take a few more years to construct a feasible social accounting matrix.
3.8 Linear Programming (LP) and Gravity Model
The standard Linear Programming (LP) Model aims at either maximizing gains (such as
national output or social welfare or employment) or minimizing losses (such as costs of
production, poverty, inequality, energy consumption, use of foreign exchange etc.)
subject to resource constraints and supply and demand balance equations. Such models
hold good only under perfect competition. But, the real world and the existing markets
are neither perfect nor competitive. Therefore, the use of LP Model is not advisable for
forecasting and planning (except for certain controlled sectors such as public transport
and public utilities).
While Linear Programming model is an optimizing model, gravity model is a behaviorist

model, mainly used for forecasting inter-regional transport flows and international trade
flows. For the transport model, transport flow (goods or passengers) from region r to
region s is estimated by the following relation:
Trs = Ar Bs Sr Ds exp (-β Crs ) for ∀r, s=1,2,3 …………….n
Where Trs = Transport flow from region r to s

Crs = Unit transport cost from region r to s
Sr = Supply of region r
Ds = Demand for region s
β = entropy parameter
Ar , Bs = Balancing parameters such that
Sr = Σ Trs summed over s for ∀r=1,2,3 …………….n
Ds = Σ Trs summed over r for ∀s=1,2,3 …………….n
For transport model in general, LP Model holds good for homogeneous goods while
gravity model holds good for heterogeneous goods and when there are aggregations over
time, over commodities and over large areas.
22
3.9 Econometric Models
Advantages of Econometric Model
An Econometric Model is the combination of mathematical and statistical techniques to

estimate best fitted relations among the macroeconomic variables. It helps:
(a) to formalize the system,

(b) to establish inter-relations among major policy variables that can be specified,
calibrated, tested, monitored, updated, simulated and predicted with certain
degree of confidence, and to identify trade-off among alternative policy options.
Steps in Econometric Modeling
(a) Specify objectives and purpose of the model.

(b) Have a sound theoretical basis for the underlying relations.
(c) Identify potential variables
(d) Specify the set of equations
(e) Identify the equations so that they are neither under nor over identified.
(f) Use suitable calibration techniques for the estimation of parameters
(g) Test the Model with the help of various goodness of fit statistics such as R² ,
χ ² , RMSE etc.
(h) Simulations/ sensitivity analysis for alternatives scenario and policy options
(i) Monitoring, reviewing and updating
(j) Prediction and Projection.
Types of Data
(a) Time series (over time- also called inter-temporal)

(b) Cross section (across consumers and regions etc. at a particular time)
(c) Pooled- Pooling of sectors or regions (urban and rural, and all states etc.)
(d) Panel - Combination of time series and cross section data
Types of variables
In order to describe various types of variables let us consider the following simple
econometric equation determining the aggregate consumption C:
Ct = a + b Yt + c Wt + d Ct-1 + e Dt + f T + Ut
Ct = Consumption in time t
Yt = Gross National Income in time t
Wt = Wealth in time t
Ct-1 = Consumption in time t-1
23
T, t = Time with value of 1 for the initial year and 2, 3, 4, …n for subsequent years
Dt = Dummy variable having a value of 1 for the years after 1991, and 0 otherwise
Ut = random error term in time t (in classical least squares Ut is assumed to be normally
distributed with zero mean and constant variance in repeated samples)
Variables used in this equation can be classified as follows:
(a) Endogenous variables (which are determined within the model) Ct, Yt
(b) Exogenous/ predetermined variable (which are not determined in the model,
rather given from outside) Wt.
(c) Lagged variable/ pre-determined variable Ct-1
(d) Parameters a , b, c, d, e, f
(e) Instrumental variable Wt. Here Wt is called an instrumental variable
implying that it could have been endogenized in the model, but has been
taken as predetermined to influence current consumption.
(f) Dummy variable (also called binary, categorical, qualitative, dichotomous
variable, which takes different values on different occasions) Dt
(g) Omitted variables (which are not considered in the model)
(h) Catch all variable (which can catch the influence of all omitted variables)
here time T is taken as a catch all variable
(i) Ut is the random error term which measures the residuals of fitted equation
over the actual values of the variable.
Types of Equations
(a) Technical relation such as Cobb-Douglas production function which shows the
technical relation between output (Y), capital (K) and labor (L)
a. Y = A Lα Kβ,
where: Y = output; L = labor input ; K = capital input and A, α and β are constants
determined by technology and returns to scale.
(b) Behavioral equation depends on the behavior of economic agents. For

example, the consumption function depends on the behavior of households.
Another well known behavioral relationship is the gravity equation used in a
transport model (also used in external trade models to determine exports and
imports), which has been described earlier.
(c)Definitional such as the incremental capital/output ratio (ICOR)
ICOR = ∆ K / ∆ Y
(d) Identities/ balance equation such as GDP = C + G + I + ST+X –M

and GNP = GDP + NFI
24
Where
GDP = Gross Domestic Product
GNP = Gross National Product
NFI = Net factor income from abroad
C = private consumption expenditure
G = government consumption expenditure
I = gross domestic investment
ST = Stocks and inventories
X = exports of goods and (non-factor) services
M = imports of goods and (non-factor) services
(a) Structural / reduced form equations
Structural equations show simultaneous two-way relationships among variables

having influences on each other, whereas reduced form shows one way relationships.
For econometric estimation, structural relations are converted into reduced form
equations. We present below a simple example involving consumption and
investment functions.
Structural Form (Closed economy with government)
Ct = a1 + b1 Yt + Ut
It = a2 + b2 Yt + b3 Yt-1 + Vt
Yt = Ct + It + Gt
Reduced form
Yt = a3 + b4 Yt-1 + b5 Gt + Wt
Where a3 = (a1 + a2)/ b6, b4 = b3 / b6, b5 =1/ b6, b6 =1 - b1- b2
Ut, Vt, Wt = (Ut+Vt)/ b6 are random error terms with standard assumptions of normal
distribution with zero mean and constant standard deviation (homoscedasticity) in
repeated samples.
3.10 Structural Macroeconometric Model
Structural macro modeling dates back to the pioneering work of Tinbergen and Klein and
subsequent work at the Cowles Commission. Keynesian macroeconomic forecasting
models, based on income-expenditure-employment relations, a set of stochastic
behavioral and technological equations complemented by suitable identities, enjoyed a
golden age in the 1950s and 1960s and progressively grew in size and sophistication of
estimation. Some of the important examples of such large scale structural models are the
Federal Reserve Board (FRB) Models, Fair’s model of the US economy, Murphy’s
Model of the Australian economy (1988), London Business School (LBS) Model,
National Institute of Economic and Social Research (NIESR) Model and HM Treasury
(HMT) model for the UK economy.
25
Critiques of Large Scale Econometric Models
Four important methodological critiques against the large scale models are worth noting:
(a) First, more than three decades ago Lucas (1976) questioned the practical
usefulness of large scale macroeconomic models as a guide to policy planning,
because most models were built on the assumption of a given structure and
stability of parameters, which did not exist in real markets because of
imperfections in knowledge and information. The Lucas critique, also known as
the policy irrelevance doctrine, remains a milestone in macro modeling literature
and more and more models (Fair 1994, Taylor 1993 and Diebold 1998) were built
to incorporate imperfections and rational expectations.
(b) Secondly, Sims (1980) raised serious doubts about the traditional modeling of
behavioral relations, because of their ‘incredible restrictions’ on the short-term
dynamics. Sims’ alternative modeling strategy led to the Vector Auto
Regression (VAR) models. While VAR models usually produce unconditional
forecasts that might outperform forecasts generated by large macroeconomic
models, their application for wide ranging policy planning is still limited.
(c) Thirdly, greater attention was paid to the treatment of non-stationarity in macro
variables. This led to modeling techniques involving cointegration and provided
a framework for model dynamics to evolve around long term equilibrium
relationships. In this sphere, major works date back to Nelson and Plosser (1982)
and Engle and Granger (1987).
(d) Finally, large econometric models suffered from what is known as the ‘curse of
dimensionality’. By including too many variables, often accidental or irrelevant
data are embodied into the model, leading to poor estimates of parameters due to
problems of multi-collinearity (Clements and Hendry 1995).
In spite of these criticisms, large models had left a rich analytical, methodological, and
empirical legacy. Diebold (1998) concludes: "Although the large-scale macroeconomic
forecasting models did not live up to their original promise, they nevertheless left a useful
legacy of lasting contributions from which macroeconomic forecasting will continue to
benefit. They spurred the development of powerful identification and estimation theory,
computational and simulation techniques, comprehensive machine-readable
macroeconomic data-bases and much else.”
It is also worth noting that noble laureate Klein (1999), one of the foremost experts on
macro modeling, continues to put faith in large size models arguing that small models
cannot capture the complex nature of an economy and that this may lead to misleading
policy conclusions.
26
3.11 Vector Autoregressive Model (VAR)
Because of their poor performance, large scale macro econometric models were followed
in the 1980s and 1990s by powerful non-structural models such as Vector Auto-
Regression (VAR) model and Dynamic Stochastic General Equilibrium (DSGE) model.
Although called structural models, these models lacked depth in their structural
specification. One of the first efforts to rectify the limitation was made by Lucas (1972)
based on a dynamic stochastic model that provided for fully articulated preferences,
technologies and rules of the game. This type of modeling was given the name of
Dynamic Stochastic General Equilibrium (DSGE) modeling.
More recently, work on autoregressive moving average (ARMA) and autoregressive

integrated moving average (ARIMA) models developed at a rapid pace with the
pioneering work of Box and Jenkins (1970). Although Box-Jenkins framework dealt
primarily with univariate modeling, extensions of the Box-Jenkins models involved
multi-variate modeling and notably Sims advocated the use of Vector Autoregression
(VAR) models. Sims (1972) had argued that the division of variables into endogenous
and exogenous variables, as done in the structural models, was arbitrary and VAR models
could avoid that by treating all variables as endogenous.
Over the past two decades vector autoregressive (VAR) analysis has become a standard
tool in empirical research. It has several advantages.
• First, it is a flexible way of modeling since it allows all past variables to have an impact
on any present variable.
• Second, it is a systems approach that takes into account the interaction of variables
among themselves.
• Third, it has desirable time series properties
Disadvantages of VAR
Though VAR analysis is a convenient tool these advantages come at a price.
• First, the number of variables that can be included in the VAR is limited because the
model is unrestricted and runs out of degrees of freedom quickly.
• "In practice, VAR modeling for more than four variables is rarely feasible" (Charemza
and Deadman 1997).
Non-structural models have been used as a powerful tool for forecasting. These are also
convenient, as no independently predicted values of exogenous variables are needed to
generate forecasts as in the case of structural models. However, as these models produce
unconditional forecasts; these are not directly useful for policy analysis.
27
3.12 General Equilibrium Model (GEM)
General equilibrium models are economy wide models and can include multi-sector,
multi-commodity and multi-economic agents.
• Such models have the advantage of responding to shocks and fulfilling the conditions of
optimality, technological feasibility and resource constrains.
• General equilibrium model has also a strong theoretical and analytical background.
• In the 1970s there were major advances in econometric estimation and test techniques
that permitted application of general equilibrium models to large data sets.
Computing general equilibrium
Until the 1970s, general equilibrium analysis remained theoretical. However, with
advances in computing power and the development of Leontief input-output matrices, it
was possible to model national economies or even the global economy. Attempts were
made by the economists and multilateral organizations to solve for general equilibrium
prices and quantities empirically.
Applied general equilibrium (AGE) models were pioneered by Herbert Scarf in 1967
and subsequently by his students John Shoven and John Whalley in 1972 and 1973,,
which provided a methodology to solve numerically the Arrow-Debreu General
Equilibrium system. In the 1980's however, AGE models lost popularity due to their
inability to provide a precise solution and their high cost of computations. Also, Scarf's
method was proved to be non-computable to a precise solution by Velupillai (2006).
Computable general equilibrium (CGE) models replaced AGE models in the mid
1980s, as the CGE model was able to provide relatively quick and large computable
models for the whole economy, and was preferred by the governments and the World
Bank. Operational CGE models are based on static, simultaneously solved, macro
balancing equations (from the standard Keynesian macro model), giving a precise and
explicitly computable result (Mitra-Kahn 2008).
Keynesian8, Post-Keynesian economists9, and neoclassical economist in general,

criticized general equilibrium theory. Specifically, they argue that general equilibrium
theory is neither accurate nor useful – that economies are not in equilibrium and that
modeling by equilibrium is "misleading", and that the resulting theory is not a useful
guide, particularly for understanding of economic crises.
8
“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set
themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm
is past the ocean is flat again”. —John Maynard Keynes, A Tract on Monetary Reform, 1923, Ch. 3.
9
“It is as absurd to assume that, for any long period of time, the variables in the economic organization, or
any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be
without a wave”. —Irving Fisher, The Debt-Deflation Theory of Great Depressions, 1933
28
More methodologically, it is argued that general equilibrium is a fundamentally static

analysis, rather than a dynamic analysis, and thus is misleading and inapplicable. The
theory of dynamic stochastic general equilibrium seeks to address this criticism.
3.13 Dynamic Stochastic General Equilibrium Model (DSGEM)
Dynamic Stochastic General Equilibrium Model
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 from microeconomic principles. Unlike traditional
macroeconometric forecasting models, DSGE macroeconomic models are not vulnerable
to the Lucas critique (Woodford, 2003, p. 11; Tovar, 2008, p. 15).
Structure of DSGE models
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 macroeconometric 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 tend to abstract from sectoral details, and include limited
number of variables. DSGE models provide logical consistency and spell out the
following aspects of the economy.
Preferences: the objectives of economic agents are specified. For example, households
might be assumed to maximize a utility function over consumption and labor efforts.
Firms might be assumed to maximize profits.
Technology: the productive capacity of economic agents are specified. For example,
firms might be assumed to have a production function, specifying the relationship
between output and inputs of labor and capital, and technological change.
Institutional framework: the institutional constraints under which economic agents

interact are also specified. In many DSGE models, this simply means that economic
agents make their rational choices within existing socio-political context, exogenously
imposed budget constraints, and specific monetary and fiscal policies.
29
Advantages and disadvantages of DSGE modeling
By specifying preferences (what the agents want), technology (what the agents can
produce), and institutions (the way they interact), it is possible to solve the DSGE model
to predict what is actually produced, traded and consumed. In principle, it is also possible
to make valid predictions about the effects of changing the institutional framework.
The DSGE model offers several following advantages.

− The key feature of DSGE model is the use of microeconomic foundations for
modeling the behavior of the aggregate economy, such as impact of changes in the
degree of competition between firms, and analyzing the effects of economic policy
measures from economic agents´ welfare point of view.
− The individual rationality behind the aggregate behavior is useful to analyze the
impact of monetary policy on private agents’ expectations. Moreover, rational
expectations differentiate effects between permanent and transitory shocks and
between anticipated and unanticipated shocks.
− The general equilibrium structure maintain in the model the consistency between flow
and stock variables, such as investment with respect to capital and the current account
balance with respect to the net foreign assets position.
− There is recent empirical evidence showing that DSGE models can have a better
forecasting performance than purely statistical models.
− The flexibility of these models allows solving a wide range of questions relevant to
the central bank, such as the role of financial frictions in the transmission
mechanisms, the role of frictions in the labor market, effects of changes in relative
prices, implications of aggregate shocks to a specific sector and others.
− Additionally, the larger structure helps to disentangle the sources of macroeconomic
fluctuations (eg, inflation of recent years has been generated by supply or demand
shocks?).
The major uses of this model are:

− to conduct policy analysis, forecast and simulations conditional on the behavior of
monetary (and / or fiscal) policy.
− to decompose macroeconomic variables on the factors that explain their fluctuations
(shocks), both in history and forecast.
− to evaluate assessment of the effects of a lower reaction to the exchange rate or a
stronger reaction to inflation.
− to estimate the non-observable variables such as the natural interest rate, the potential
output, the real exchange rate equilibrium and the natural unemployment rate.
− to assess the impact of economic policy measures in the long term using the steady
state equilibrium.
− to estimate all of them simultaneously and in consistency framework.
However, given the difficulty of constructing accurate DSGE models, most central banks
still rely on traditional macroeconometric models for short-term forecasting. However,
the effects of alternative policies are increasingly studied by DSGE methods.
30
Examples of DGSE Model
One well-known example of the DSGEM is that of Kydland and Prescott (1982) model
which argued that a neo-classical model driven by technology shocks could explain a
large part of US business cycles. These models, also initially called real business cycle
models, combine preferences with technologies. Kydland and Prescott (1982) used non-
linear quadratic models so that non-linearity in technologies can be accommodated.
Although solving these models is not a straightforward exercise, in most cases these are
approximated by vector autoregressions. In estimating the DSGE models, formal
estimation is often combined with calibration methods, a good description of which is
available in Kydland and Prescott (1996).
More recent arguments favor formal estimation of the DSGE models and search for best
fitting parameters. Maximum likelihood estimators have been the most preferred
estimators. Current work on DSGE modeling aims at accommodating heterogeneity in
agents using representative agents and suitable aggregator functions. One characteristic
of DSGE models is their parsimony.
The European Central Bank (ECB) has developed a DSGE model, often called the
Smets-Wouters model, which analyzes the economy of the Eurozone as a whole (without
analyzing individual European countries separately). The model is intended as an
alternative to the Area-Wide Model (AWM), a more traditional empirical forecasting
model which the ECB has been using for several years. The ECB webpage that describes
the Smets-Wouters model also discusses the advantages of building a DSGE model
instead of relying on more traditional methods.
Equations in the Smets-Wouters model describe the choices of 3 types of decision

makers: households, who choose how much to work, to consume, and to invest; firms,
which choose how much labor and capital to employ; and the central bank, which
controls monetary policy. The parameters in the equations were estimated using Bayesian
statistical techniques so that the model approximately describes the dynamics of GDP,
consumption, investment, prices, wages, employment, and interest rates in the Eurozone
economy. In order to accurately reproduce the sluggish behavior of some of the variables,
model incorporates several types of frictions that slow down adjustment to shocks,
including sticky prices and wages, and adjustment costs in investment.
Critics of DSGE Model
In his blog for the Financial Times, Willem Buiter has argued that DSGE models can be
misleading. In his view, DSGE models rely excessively on an assumption of complete
markets, and are unable to describe the highly nonlinear dynamics of economic
fluctuations, making training in 'state of the art' macroeconomic modeling 'a privately
and socially costly waste of time and resources'.
31
N. Gregory Mankiw, regarded as one of the founders of New Keynesian DSGE

modeling, has argued that 'Neoclassical and new Keynesian research has little impact on
practical policy makers. From the standpoint of macroeconomic engineering, the work of
the past several decades of modeling looks like an unfortunate wrong turn.
Replying to Mankiw, Michael Woodford argues that DSGE models are commonly used
by central banks today, and have strongly influenced policy makers. However, he argues
that what is learned from DSGE models is not so different from traditional Keynesian
analysis.
Making an assessment of the future of macroeconomic modeling and forecasting,

Diebold (1996) wrote: “The hallmark of macroeconomic forecasting over the next 20
years will be a marriage of the best of nonstructural and structural approaches,
facilitated by advances in numerical and simulation techniques that will help
macroeconomics to solve, estimate, simulate, and yes, forecast with rich models”.
32
Annex-4
Data required for Macroeconomic Model
I T E MS 1985 1986 1987 .. .. 2006
A. Population (million, as on 2 July
Population growth rate (% per annum)
Work force (age 15-65 years)
Employment (in '000)
Total
Agriculture
Industry
Services
B. GDP: Supply Side

1. GDP const FC (Mill. NR)
Agriculture and allied
Industry
-- Manufacturing
… Mining and quarrying
-- Electricity, gas, water supply
-- construction
Services
-- Trade, hotels and restaurants
-- Transport, storage, commn.
-- Financial, real estate, business
-- Community, social, personal
GDP const 2004 FC (Mill. NR)
(Plus) Indirect taxes less subsidies
GDP at cons mp (Mill. NR)
2. GDP at current mp (Mln NR)
Industry
-- Manufacturing
-- construction
Services
GDP at current market prices
(Less) Indirect taxes less subsidies
GDP at current FC (Mill. NR)
33
I T E MS 1985 1986 1987 .. .. 2006

C. Demand side of GDP:
1.GDP at constant price (GDP) (Mln NR)
=a+b+c+d+e-f+g
(a) Private consumption
(b) Government consumption
(c) Gross fixed capital formation
(d) Change in stocks
(e) Exports of goods and services
(f) Imports of goods and services
(g) Statistical discrepancy
2.GDP at current mp (Mln NR) =a+b+c+d+e-f+g
(a) Private consumption
(b) Government consumption
(c) Gross fixed capital formation
(d) Change in stocks
(e) Exports of goods and services
(f) Imports of goods and services
(g) Statistical discrepancy
3. Investment (at constant prices)

Industry
-- Manufacturing
-- construction
Services
4. Investment (at current prices)
Industry
-- Manufacturing
-- construction
Services
34
I T E MS 1985 1986 1987 .. .. 2006

5.Investment Financing at current mp (Mill NR)
5. Gross domestic capital formation = 4(c)+ 4(d)
--- Public investment
--- Private investment
D.Gross national saving =a+b+c
(a) Gross domestic saving
--- Public savings
--- Private savings
(b) Net factor income from abroad
(c) Net current transfers from abroad
E. Agriculture sector
1 (a) Total cropped area (000 hectares)
(b) Irrigated area ('ooo hectares)
(c) Average rainfall (mm per day)
(d) Rainfall dispersion over months (mm per day)
(e) Food grains production (000 tones)
2. Agriculture production index 1999-2001=100
Manufacturing prod. index 1986/87 = 100

Electricity consumption (Million KWH)
Exchange rate and Inflation
Ave Exchange Rate (NR/US$)
GDP at current mp (mn US$)
Percapita GDP current mp (US$)
Consumer (Urban) Price Index (1995/96=100)
Food
Non-Food
CPI Inflation (Annual % change)
Food
Non-Food
Implicit GDP Deflator
Balance of Payments (Million US$)

Goods balance
Exports of goods f.o.b.
Imports of goods c.i.f.
Non-factor services and factor incomes,
net
Credits
Debits
Transfers, net
Official, net
Private, net
35
I T E MS 1985 1986 1987 .. .. 2006

BOP continued:
Remittances
Current account balance (CAB)
Exports of goods & services
Imports of goods & services
Capital account
Official loans, net
Loans
Amortization (AMORT)
Private capital inflow
FDI, net
Other investment, net
Errors and omissions
Overall balance
Foreign exch reserve end period
Equivalent to months of imports
Exports of goods to India
Exports of goods to China
Imports of goods from India

Imports of goods from China
Central Govt Operations (Billion NR)
1.Total Revenue and grants = 1.1+1.2
1.1 Total revenue = (a) + (b)
(a) Current Revenue = (i)+(ii)
(i) Tax revenue
(ii) Nontax revenue
(b) Capital receipts
1.2 Grants
2. Total Expenditure and net lending = 2.1+2.2
2.1 Total expenditure = (a) + (b)
(a) Current expenditure

--- Wages and salaries
--- Other charges
--- Interest payments
(b) Capital expenditure and net lending
--- Capital expenditure
--- Net lending
3. Current A/C Balance =1.1(a) - 2.1 (a)
4. Capital A/C Balance = 1.1 (b) - 2.1 (b)
5. Overall Fiscal Balance = 1-2 = 3+4
6. Primary Balance = 5 - Interest payments
36
I T E MS 1985 1986 1987 .. .. 2006

Monetary survey (Billion NR)
Net foreign assets
Net domestic assets
Domestic credits
Claims on government, net
Claims on public enterprises, net
Claims on private sector, net
Claims on financial institutions
Other items, net
Broad money (M3) demand
Broad money (M3) supply = M1+Time Deposits
Quasi Money (M1) = (a) +(b)
(a) Currency outside banks
(b) Demand Deposits
Time Deposits
Interest Rates (% per annum)
Savings deposit rate
Term deposit rate (one year)
Bank lending rate
NRB Bank rate
External Debt Outstanding: (Million US$)

Medium and long term
Public and publicly guaranteed
Private non-guaranteed
Short-term debt
Use of IMF credits
External debt service

Amortization
IMF
Interest payments
IMF
Short Term
Average Terms of external borrowing:

Interest (percent per annum)
Maturity (years)
Grant period (years)
Grant element (percent)
37
Annex-5: Terms of Reference for the Modeling Consultants
Component B: Macroeconomic Modeling
5.1 Macroeconomic Modeling Specialist/Team Leader (international, 6 person

months) will perform the following tasks:
(i) Update the Nepal Macroeconomic Model (NMEM) based on the new system of
national accounting adopted by CBS and changes in the structure of the Nepalese
economy;
(ii) develop a new dynamic stochastic general equilibrium (DSGE) type model suitable
for Nepal;
(iii) develop software for updated NMEM and DSGE-type macro models;
(iv) develop a user manual for both the NMEM and DSGE-type model that includes the
calibration methodology;
(v) devise a model consistent with the data linkages and reporting systems required for
an efficient modeling exercise, and ensure the sustainability of efforts in the area of
macroeconomic modeling in Nepal;
(vi) undertake growth and macroeconomic projections for the Nepalese economy and
compare the consistency of results from both the models;
(vii) provide training to the staff of the agencies involved, and other agencies suggested
by the steering committee and the technical committee, on features of the models and
software to enable them to undertake the modeling exercise independently;
(viii) work closely with the national consultants and provide guidance on their respective
assignments and supervise their work;
(ix) arrange the facilities for workshops, training, seminars, and dissemination of the
findings;
(x) undertake consultations with all stakeholders and incorporate feedback from
developing the two models and other expected outputs of the TA;
(xi) work closely with the Executing Agency (EA), the steering committee, technical
committee, and other relevant stakeholders for developing the models;
(xii) oversee overall TA implementation and prepare required reports;
(xiii) coordinate the procurement of hardware and software needed for upgrading the
software for NMEM and the new model with ADB, the EA, and the national information
technology specialist; and
(xiv) undertake other tasks as required by the steering committee and ADB.
5.2 Macroeconomic Modeling Specialist (national, 5 person-months) will perform the

following tasks:
(i) review the previous macroeconomic modeling work in Nepal, identify gaps and
provide suggestions for upgrading the NMEM and DSGE-type of model for Nepal;
(ii) provide the data inputs on Nepal required by the team leader to upgrade the NMEM
and develop a new DSGE-type model for Nepal;
(iii) assist the team leader in undertaking the macroeconomic modeling and
macroeconomic forecasting for the Nepalese economy;
38
(iv) assist the team in designing models that are based on economic principles and
methodology for macroeconomic modeling of the economy;
(v) assist the international consultant in upgrading the NMEM and developing the DSGE
model for Nepal;
(vi) train staff in the EA on the features of the economy, and interpretation of the results;
(vii) participate in the consultation process and incorporate feedback;
(viii) work closely with the team leader, EA, steering committee, and technical
committee, and provide required inputs; and
(ix) undertake other tasks as required by the steering committee and ADB.
5.3 Econometrician (national, 5 person-months) will perform the following tasks:
(i) assist the team leader on data needs and calibration methods for upgrading the NMEM
and developing a new DSGE-type macro model;
(ii) assist the team leader in designing the models that are statistically sound and yield
robust results;
(iii) assist the team in designing models that use appropriate econometric principles and
methodology for macroeconomic modeling of the economy;
(iv) train EA staff on data requirements, inputs to the model, calibration methods, and
running the models;
(v) participate in the consultation process and incorporate feedback;
(vi) work closely with the team leader, EA, steering committee, and technical committee;
and provide required inputs; and
(vii) undertake other tasks as required by the steering committee and ADB.
5.4 Information Technology Specialist (national, 2 person months) will perform the
following tasks:
(i) check the specifications of the hardware and software that have been purchased and
installed at the Nepal Rastra Bank (NRB) and their connectivity to the databases at NRB
and CBS;
(ii) install the new macroeconomic modeling software in the NRB and ensure that staff at
NRB can install the software in case need arises;
(iii) complete the database migration to the new modeling format;
(iv) undertake data validation and train the staff of the NRB on database and system
maintenance activities; and
(v) undertake other tasks as required by the steering committee and ADB.
39
Annex-6.1 Brief Curriculum Vitae of Prof. Tarun Das
Prof. TARUN DAS, Ph.D.

International Modeling Specialist
E-mail: das.tarun@hotmail.com
Formerly: Economic. Adviser, Ministry of Finance and
Adviser ( Modeling), Planning Commission, Govt. of India,
Professor (Public Policy), IILM, New Delhi and
ADB Strategic Planning Expert ,Min of Finance, Govt of Mongolia.
Google search: Tarun Das, Economic Adviser, Ministry of Finance
Specialization Macro-economic modeling; public policy; governance reforms;
strategic planning, performance based output budgeting; poverty
and inequality measures; MDGs; National Plans, PRSP and PGRF;
management of public debt and ccontingent liabilities.
Diversity in skills Possesses diversity in skills in research, training, teaching,
modeling, policy planning and consultancy services.
Worked as Consultant to African Development Bank, Asian Development Bank, GDN,
various international World Bank, IMF, ILO, UN-ESCAP, UNCTAD, UNDP, UN-ECA,
organizations: UNITAR, UN-SIAP, Commonwealth Secretariat.
Countries worked in: Cambodia, China, Ethiopia, Gambia, India, Indonesia, Japan, Lao
PDR, Malaysia, Mongolia, Nepal, Philippines, Samoa, Senegal,
Singapore, Switzerland, Thailand, UK and USA.
Attended Conferences in: Bangladesh, Belgium, France, Germany, Morocco, Ireland, U.A.E.
Published Papers in Australian Economic Journal, Empirical Economics (Vienna),
International Journals: Environment and Planning (London), International Review of
Economic and Commercial Science (Milan), Review of
Mathematical Economics and Social Science (Milan). Journal of
Income and Wealth, Journal of Regional Economics.
Educational Gold Medalist in Quantitative Economics from Calcutta University,
Qualifications: and holds a Ph.D. degree, as Commonwealth Scholar, from the East
Anglia University, England.
Major Professional Experiences in Backward Sequence:
23 Aug 2009-till date International Macroeconomic Modeling Specialist, ADB Resident

Office in Nepal at Kathmandu and Nepal Rastra Bank.
20 Dec 08-10 Aug 09. African Development Bank Macroeconomic Adviser, Ministry of
Finance and Economic Affairs, the Gambia, Banjul.
Nov 2008- 10 Dec 08 Consultant to UN-ESCAP, Bangkok, Thailand.
Sep 2008 – Oct 2008 Consultant to World Bank Country Office (Tashkent, Uzbekistan).
Jul 2008- Aug 2008 Consultant (Debt Sustainability Analysis), Com-Sec, London, U.K.
June 2007- Jul 2008 ADB Strategic Planning Expert, MOF, Mongolia, Ulaanbaatar.
Feb 2006- May 2007 Professor (Public Policy), IILM, New Delhi-110003, India.
Mar 1989- Jan 2006 Economic Adviser, Ministry of Finance, Government of India.
Jan 1987- Feb 1989 Adviser (Modeling & Policy Planning), Planning Commission, Ind.
Oct 1984- Dec 1986 Chief Economist, Joint Plant Committee, Ministry of Steel, India.
Oct 1982- Sep 1984 Chief (Eco. Division), Bureau of Industrial Costs and Prices, India.
Sep 1978-Sep 1982 Deputy Adviser, UNDP Transport Modeling Project in India.
40
Annex-6.2: Brief Curriculum Vitae of Prof. Durga Lal Shrestha

Macroeconomic Modeling Specialist
Name: Dr. Durga Lal Shrestha

1. Date of Birth; September 13, 1952
2. Academic Qualification:
• Ph. D. in Economics, Moscow, USSR, 1990.
• Master of Arts (M.A.) in Economics, Merit(First) Class, TU,
Nepal, 1977
• Dr. Shrestha has 31 years of teaching and research experiences in Tribhuvan

University (TU) of Nepal. Presently, he is the Professor at Centre for Economic
Development and Administration (CEDA), a research centre of TU, Kathmandu.
• In addition to teaching and research, he served in TU tendering different academic
and administrative posts such as: Department Head, Assistant Campus Chief, Campus
Chief, Extracurricular Activity Chief, Member of Economics Subject Standing
Committee, and Member of Scrutiny Board in Controller of Examination of TU.
• Dr. Shrestha worked as national consultant (Input-Output Model Expert) in
Strengthening National Planning Commission (NPC) Project during (1992-1993).
• He worked as an Advisor to the Hon’ble Member for Physical Infrastructure and
Water Resources Development Section of the Government of Nepal, NPC Secretariat,
for the formulation of the Ninth Plan in 1997-1998.
• He worked as an Input-Output Model expert for Perspective Energy Plan in 1995
and for the Tenth Plan in 2002 in the Government of Nepal, NPC Secretariat.
• He worked as resource economist/ Modeling expert in Phase I, II and III of Water
resources Strategy Formulation in three different periods i.e., 1996, 1999 and 2004
respectively for the Government of Nepal, and Water and Energy Commission.
• He worked as national macro-economic modeling specialist in the development
Nepal Macroeconomic Model for debt sustainability analysis in the Government of
Nepal Ministry of Finance (MOF) in 2005. Recently, he has also worked as
Macroeconomist/Modeling Expert in the Energy Strategy Formulation Project of the
Government of Nepal, Water and Energy Commission.
• He also worked as a Visiting Senior Research Fellow at the Department of
Economics, the University of Bergen of in 2001. He was involved as a team member
in the Norwegian Review Team of the Melamchi Water Supply Project in 2004.
• Besides, being as a team leader, or a consultant or a researcher he has
accomplished many research projects of different fields of economics such as:
national planning, macro modeling, input-output modeling, Mid Term Expenditure
Framework (MTEF), energy, water resources, hydropower pricing, high value
agriculture crops, education, private sector development, tourism, industrial relation,
and transportation.
41
Annex 6.3:
CV of Dr. Vikas Raj Satyal
National Econometrician
1. Personal data:
Name : Vikash Raj Satyal
Address: Shantinagar, Kathmandu, Nepal. Tel: 9771- 4492685,
Cell: 9841413453 Email: vrsatyal@gmail.com
2. Education
• 1994: Ph.D. (Statistics), University of Vienna, Austria
• M.Sc. (Statistics), Tribhuvan University, Nepal.
3. Other qualification
Course attended: Operational Research, Vienna University, 1994.
Training: Logical Frame Approach, IIDS, Kathmandu, 2003
Computer ability: SPSS, MINITAB, SAS, EVIEWS
4. Work Experience
• 1986- date: Tribhuvan University, Nepal: currently as Associate Prof./ Head,
Department of Statistics, Amrit Campus
• 1996 to-date: Consultant-Statistician, Institute for Integrated Development Studies
(IIDS), Madikhatar, Maharajgunj, Kathmandu
• 2001(4 months): Consultant Statistician/Survey Manager-"Industrial Development
Prospective Plan – Vision 2020", United Nations Industrial Development Organization
(UNIDO)/ United Nations Development Program (UNDP), Kathmandu.
5. Major Publication
• 2008: Kingdom of Nepal: Technical Assistance to Nepal for Reaching the Most
Disadvantaged Groups in Mainstream Rural Development (co-author), ADB (web
based)
• 2007, Nepal: Social Security for the Elderly, (co-author), ed. Irudaya Rajan, Social
Security for the Elderly in South Asia, Rutledge Taylor Francis.
• 2007: Targeted Development Programs in Nepal: A Selective Review (co-author),
IIDS/ESP/DfID, Nepal
• 2006, Economic Growth in Nepal, 1996-2000, (co-author), ed. Kirith S. Parikh,
Explaining Growth in South Asia, Oxford University Press, London
• 2006, Nepal Country Report: Research & Dialogue with Political Parties(co-author),
International IDEA, Stockholm(web based)
• 2006, Nepal: Conflict Resolution and Sustainable Peace: Decentralization and
Regional Development (co-author), IIDS
• 2003: Gender Budget Audit in Nepal (Co-author) : The United Nations Development
Fund for Women (UNIFEM/Nepal)
• 2000: Macro-Economic Modeling of South Asian Economies with Intra-SAARC Trade
Link (co-author): GDN/SANEI
42
Annex 6.4:
Curriculum Vitae of National IT Specialist
Name: Mr. Rojan Bajracharya
Address: GPO Box 12558, Kathmandu, Nepal

Tel: +911-1-4282629,
Fax: +977-1-4373682
Email: rojan@email.com, rojanbajracharya@gmail.com
Education Qualification: Master’s Degree in Economics from Tribhuvan University (2002 to

2005), Thesis Title “Macro Econometric Analysis of Nepal with reference to Macro Modeling
Exercise between 1990 to 2005”
Work Experience
Econometric Modeling Assignment

Worked as Core Team Member of Research Study on “Crafting a Socially Inclusive Service
Policy to Address Vulnerability of Marginalized Communities: Lessons from Nepal’s Education
Policy “ funded by Global Development Network under Global Development Award (February to
December 2008)
Worked as Junior Researcher of Research Study on “Impact of OECD Countries’ Agricultural

Liberalization on Household Welfare in Nepal” funded by Global Development Network (July
2005 to December 2006)
Worked as Program Expert to Institute for Policy Research and Development (IPRAD) team on
programming the simulation part of Macro Econometric Model (1st to 30th November 2004)
Worked as Project Associate in ADB/TA on Strengthening Institutional Capacity for Effective

Public Debt Management (August 2003 to December 2005)
Other Work Assignments

Working as Communication Consultant for Social Inclusion Research Fund, SNV Nepal
(February 2009 to Still)
Worked as Education Consultant for ‘South Asia Watch for Trade, Economic and Environment’
in UNDP funded research study on “Nepal’s Service Sector Export Potential” (January to
February 2008)
Publication
Edited Book “Social Inclusion and Nation Building: Abstracts of Researches Supported by Social
Inclusion Research Fund” Published by Social Inclusion Research Fund, SNV Nepal (2009)
Co- Authored Article on “ Rising Food Price in South Asia” in Trade Insight, May 2008 Issue
Software Knowledge
Working Econometric Software: Eviews
Working Statistical Software: SPSS
43
Annex 7.1-A Work Plan Milestones for Prof. Tarun Das

For Component B: Development of Macroeconomic Model for Nepal
Work Plan Milestones:
1. Preparation of the First Draft of the Inception Report by 10 September 2009

2. Review the NMEM and identify deficiencies and their causes by 15 September 2009
3. Conduct research, identify data base and upgrade the NMEM by 22 September 2009
4. Develop an operational DSGE Model for Nepal by 08 October 2009.
5. Prepare a Report on the choice of software and hardware by 08 October 2009
6. Preparation of the Second Draft of the Inception Report by 08 October 2009.
7. Submission of the Final Inception Report incorporating all works until date- by the
16 October 2009
8. Installation of Software/ hardware Testing by 31st January 2010
9. Test, calibrate and simulate the upgraded NMEM by 15 March 2010
10. Undertake research and finalize a DSGE-type model for Nepal by 31 March 2010
11. Test, calibrate and simulate the DSGE-type model by 30 April 2010.
12. Conduct multi-stakeholders’ seminars/ workshops on the features of the two models by
15 May 2010
13. Develop and calibrate short-term forecasting model for major variables of interest to
NRB by the 31 May 2010
14. Preparation of macroeconomic and fiscal envelope for the Ministry of Finance to provide
pre-budget inputs to MOF for preparation of the 2010-2011 Budget by 31 May 2010
15. Develop a user manual, including calibration methodology, to undertake quantitative
macroeconomic analysis using the DSGE model by 31 May 2010
16. Conduct seminars/ workshops on the features of the two models by 30 Sep 2010
17. 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.
18. Prepare Terminal Report by 4 October 2010.
Proposed Phases Period Number of working Total Working days

days (Total Days)
First Phase 24 Aug 2009 to 33 (55) 33
16 Oct 2009
Leave of Absence 17 Oct 2009 to 0 (121) 33
15 Feb 2010
Second Phase 16 Feb 2010 to 75(105) 108
31 May 2010
Leave of Absence 1 June 2010 to 0 (67) 108
31 Aug 2010
Third Phase 1 Sept 2010 to 24 (33) 132
04 Oct 2010
44
Annex-7.1-B Work Plan Matrix of Prof. Tarun Das, International Consultant

(132 working days during August 2009- October 2010)
Tasks 24 Aug ’09 16 Feb ‘10 01 Sep ‘10

to 16 Oct to 31 May to 04 Oct
2009 2010 2010
(i) Update the Nepal Macroeconomic Model (NMEM) √ √
based on the new system of national accounting adopted
by CBS and structure changes in the Nepalese economy;
(ii) develop a new dynamic stochastic general equilibrium √
(DSGE) type model suitable for Nepal;
(iii) develop software for updated NMEM and DSGE-type √
macro models;
(iv) develop a user manual for both the NMEM and √
DSGE-type model that includes the calibration
methodology;
(v) devise a model consistent with the data linkages and √ √
reporting systems required for an efficient modeling
exercise, and ensure the sustainability of efforts in the
area of macroeconomic modeling in Nepal;
(vi) undertake growth and macroeconomic projections for √ √
the Nepalese economy and compare the consistency of
results from both the models;
(vii) provide training to the staff of the agencies involved, √ √
and other agencies suggested by the steering committee
and the technical committee, on features of the models
and software to enable them to undertake the modeling
exercise independently;
(viii) work closely with the national consultants and provide √ √ √
guidance on their respective assignments and supervise
their work;
(ix) arrange the facilities for workshops, training, √ √
seminars, and dissemination of the findings;
(x) undertake consultations with all stakeholders and √ √ √
incorporate feedback from developing the two models
and other expected outputs of the TA;
(xi) work closely with the Executing Agency (EA), the √ √ √
steering committee, technical committee, and other
relevant stakeholders for developing the models;
(xii) oversee overall TA implementation and prepare √ √ √
required reports;
(xiii) Coordinate the procurement of hardware and software √
needed for upgrading the software for NMEM and the
new model with ADB, the EA, and the national
information technology specialist; and
(xiv) Undertake other tasks as required by the steering √ √ √
committee and ADB.
Total Working Days 33 75 24
Note: The appropriate period cell is ticked (√) in if a particular task continues during that period. Under the number of
total working days (last row in the matrix), the expected number of working days in each period is indicated.
45
Annex-7.3 Work Plan Matrix of Prof. Durga Lal Shrestha,

National Macroeconomic Modeling Specialist
((110 working days spread over 5 months)
Tasks 24 Aug ’09 16 Feb ‘10 01 Sep ’10

to 16 Oct to 31 May to 04 Oct
2009 2010 2010
(i) review the previous macroeconomic √ √
modeling work in Nepal, identify gaps and
provide suggestions for upgrading the NMEM and
DSGE-type of model for Nepal;
(ii) provide the data inputs on Nepal required √ √
by the team leader to upgrade the NMEM and
develop a new DSGE-type model for Nepal;
(iii) assist the team leader in undertaking the √ √
macroeconomic modeling and macroeconomic
forecasting for the Nepalese economy;
(iv) assist the team in designing models that √ √
are based on economic principles and
methodology for macroeconomic modeling of the
economy;
(v) assist the international consultant in √ √ √
upgrading the NMEM and developing the DSGE
model for Nepal;
(vi) train staff in the EA on the features of the √ √

economy, and interpretation of the results;
(vii) participate in the consultation process √ √ √

and incorporate feedback;
(viii) work closely with the team leader, EA, √ √ √

steering committee, and technical committee, and
provide required inputs; and
(ix) undertake other tasks as required by the √ √

steering committee and ADB.
(x) Attend meetings (steering
Committee/ and other)
Total Working Days 11 75 24
Note: The appropriate period cell is ticked (√) in if a particular task continues during that period. Under the number of
total working days (last row in the matrix), the expected number of working days in each period is indicated.
46
Annex 7.4 Dr. Vikash Raj Satyal, National Econometrician

Work plan matrix (110 working days spread over 5 months)
Items 24 Aug ’09 to 16 Feb ‘10 to 01 Sep ’10 to
16 Oct 2009 31 May 2010 04 Oct 2010
1. SWOT analysis for √
inception report
2. Assist TL on data need and √

calibration methods
3. Assist the TL in designing √

statistically sound models
4. Assist the team in designing
models that use appropriate
econometric principles and
methodology for
macroeconomic modeling
of the economy
5. Train EA staff on √
software/data requirements,
inputs of the developed
model
6. Attain meetings √ √ √
(steering Committee/
and other)
7. Assist TL in report √
preparation
Total working days 11 75 24
47
Annex 7.5 Mr. Rojan Bajracharya, National IT Specialist

Work plan matrix (44 working days spread over 2 months)
24 Aug 2009 to 04 Jan 2010 to 01 Sep 2010 to

Items of Activities 16 Oct 2009 24 Feb 2010 30 Sep 2010
(i) Assist TA
team leader to
prepare the TA √
Inception Report
(ii) Check the
specifications of the
hardware and
software that have
been purchased and
installed at the √ √
Nepal Rastra Bank
(NRB) and their
connectivity to the
databases at NRB
and CBS;
(iii) Install the
new
macroeconomic
modeling software
in the NRB and √
ensure that staff at
NRB can install the
software in case
need arises;
(iv) Complete
the database
migration to the √ √
new modeling
format;
(v) Undertak
e data validation
and train the staff of
the NRB on
database and
system maintenance
activities; and
(vi) Undertak
e other tasks as
required by the √ √ √
steering committee
and ADB.
Working Days 12 24 8
48
Annex-8
Broad Features of EViews 6 Software
8.1 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.
49
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
8.2 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.
8.3 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,
50
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.
51
8.4 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.
52
Annex-8B
EViews 6.0 Commercial and Government Prices
All copies of EViews 6.0 come with complete documentation provided in PDF format on
the EViews CD. Printed versions of the documentation, three volumes with over 2388
pages, are available with software purchase at a discounted price of $75.
New purchases of EViews 6.0 come with printed copies of EViews Illustrated by Richard
Startz (416 pages). This primer on the use of EViews is available with EViews upgrades
at additional charge.
EViews Enterprise Edition has all the features of the Standard Edition plus support for
ODBC and support for proprietary data formats of commercial data and database
vendors. Specifically, support for ODBC, Datastream, EcoWin, FactSet, FAME (local
and server), Global Insight DRIBase, Haver Analytics, and Moody’s Economy.com
databases, is only provided in EViews Enterprise Edition.
The U.S. dollar prices listed below (which do not include shipping and handling) is for
purchases made directly from QMS. International prices may vary. Please check with
your local distributor.
Version Price
CD only CD & Manuals
EViews Standard Edition 6.0 + EViews Illustrated $975 $1,050
EViews Enterprise Edition 6.0 + EViews Illustrated 1,275 $1,350
53
54
9. List of Officers Consulted
1. ADB Nepal Resident Mission, Srikunj, Kamaladi, Kathmandu
Mr. Raju Tuladhar, Senior Programs Officer, ADB, NRM.

Mr. Shahid Parwez, Program/ Project Implementation Officer, ADB NRM.
2. Nepal Rastra Bank, Baluwater, Kathmandu
Mr. Ravindra Prasad Pandey, Executive Director (Research Department), NRB.

Mr. Trilochan Pangeni, formerly Executive Director (Research Department), NRB.
Dr. Nephil M. Maskay, Director, Research Department, NRB
Mr. Ramesh Kumar Pokharel, Director (Research), NRB
Dr. Bhubanesh Pant, Director (BOP), NRB.
Dr. Bamdev Sigdel, Deputy Director, Research Department, NRB
Dr. Gopal Prasad Bhatta, Deputy Director (Prices), NRB.
Ms. Neelam Timsina, Deputy Director (Government Finance), Research, NRB.
Mr. Rajendra Prasad Pandit, Deputy Director, Research, NRB.
Mr. Pitambar Bhandari, Deputy Director, NRB.
Dr. Ramsaran Kharal, Assistant Director, Research Department, NRB
Mr. Madhav Dahgul, Assistant Director, Research, NRB.
Mr. Satyendra Subedi, Assistant Director, Research, NRB.
Mr. Ishwari P. Dhattarai, Assistant Director (BOP), Research, NRB.
Mr. Govinda Nagila, Assistant Director (Government Finance), NRB.
3. National Planning Commission

Mr. Puspa Sakya, Joint Secretary, Macro Economic Division, NPC
Mr. Rabi Saiju, Under Secretary, Macro Economic Division, NPC
Mr. Baikuntha Aryal, Under Secretary, Macro Economic Division, NPC
Mr. Kamal Paudayal, Section Officer, Macro Economic Division, NPC
4. Central Bureau of Statistics

Mr. Uttam Narayan Malla, Director General, Central Bureau of Statistics
Mr. Suman Raj Aryal, Director, Central Bureau of Statistics
5. Ministry of Finance
Mr. Janak Pant, Under Secretary, Economic Affairs and Policy Analysis Division, MoF
Mr. Tikaram Aryal, Section Officer, Economic Affairs and Policy Analysis Division.
6. 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
55

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Nepal Macroeconomic Model- Inception Report

INCEPTION REPORT (FINAL):

DR. TARUN DAS1,2

NEPAL GEOGRAPHIC MAP

Political and Administrative Structure

Basic Facts about Nepal:

ANNEX-1: ECONOMIC CONTEXT OF MODELING 4-13

ANNEX-2: BUILDING UP OF AN OPERATIONAL MACROECONOMIC MODEL 14-17

ANNEX-6: BRIEF CV OF THE CONSULTANTS 40-43

ANNEX-7: WORK PLAN MATRIX OF CONSULTANTS 44-48

ANNEX-8A: BROAD FEATURES OF E-VIEWS 6 SOFTWARE 49-52

1.1 Global Financial-Food-Fuel Crisis and Economic Slowdown

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

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

1.2 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

As is evidenced by Table-1.2, exports of goods and services and external transfers

Table-1.2: Nepal: Measures of globalization

1.3 Recent Economic Development in Nepal

Table-1.3: Recent Trends of Major Economic Indicators of Nepal

Despite sound macroeconomic management by the government, foreign investors stayed

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

The strategies of the Plan include the following:

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

(c) Social Development Indicators and MDGs

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

Table-1.4 Nepal: Social Development Indicators

1.4 External Debt Situation

Table-1.5 External Debt Situation in Nepal (US$ Million)

1.5 Economic Outlook, Problems and Prospects

2.1 Basic Purpose and Dimensions of a Macroeconomic Model

• Sectoral GDP and overall GDP

 How can we understand such a complex system?

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

 Government Financial Statistics produced by the MOF

A modeller also faces the following questions while specifying models.

2.2 Alternative Macroeconomic Models

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

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

(vi) Dynamic Stochastic General Equilibrium (DSGE) Model

2.3 International Best Practices and Lessons for Macroeconomic Modeling

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

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

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

3.1 Scope of Modeling and Forecasting

3.2 Factors affecting modeling

Before building an economic model, we need to take decisions on a number of factors

(d) Regional disagregation- For consistency, macroeconomic modeling may be

3.3 Types of Models

There are various types of macroeconomic Models as indicated bellow:

3.4 Desirable characteristics of an Ideal Model

3.5 Various Operational Macroeconomic Models

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

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

3.6 Macro-economic Model in Leontief Input-Output Framework

The basic macroeconomic model in Leontief Input-Output Framework consisting of n

Public consumption is estimated by the social welfare programs. Investments is estimated

3.7 Social Accounting Matrix and General Equilibrium Model

3.8 Linear Programming (LP) and Gravity Model

While Linear Programming model is an optimizing model, gravity model is a behaviorist

Trs = Ar Bs Sr Ds exp (-β Crs ) for ∀r, s=1,2,3 …………….n

Where Trs = Transport flow from region r to s

3.9 Econometric Models