Monetary Policy Rules When UIP Conditions and Policy Trilemma Do Not Hold: The Case of Nepal

We investigate the rationale of a rule-based monetary policy in Nepal, applying the modified Taylor (1993, 2001) rule. Our first condition is that uncovered interest parity (UIP) does not hold, and we therefore incorporate the risk premium in the Taylor rule. We also condition that the policy trilemma does not hold by assigning a higher weight to foreign interest rates. We include the simulated risk premium from an earlier publication (Bhatta et al, 2022a). The findings from the generalized method of moments (GMM) model with quarterly data from 2000 to 2020 demonstrate that a modified Taylor rule partially holds for Nepal while the real effective exchange rate (REER) being the dominant factor with negative sign of inflation expectations. These findings indicate that REER characterizes the role of inflation expectations for Nepal, and the monetary policy accommodates remittance income via the REER. The central bank, therefore, should consider foreign factors like REER and foreign inflation targets while setting up the policy rule.