KATHMANDU: There is often a debate in the context of Nepal’s medium- to long-term growth and stabilization strategies as to what should be emphasized more: consumption expenditure or investment expenditure.

Some argue that it is private final consumption expenditure (PFCE) that is important, and that Nepal’s growth strategy should be driven by encouraging consumption because remittance inflows playing a dominant role in household expenditure, recent macroeconomic trends and structural challenges invite a deeper look into the long-term implications of both consumption and investment expenditures. Thus, these factors reinforce the critical role of PFCE in shaping Nepal’s economic trajectory and its resilience in the face of external shocks.

The domestic economic activity recovered from structural shocks such as Earthquake and Co-vid pandemic with consumption demand acting as the main driver. Both theoretical and empirical arguments support this position.

Nepal’s Economic Context

Nepal is a low-income country with unique economic features: high dependency on remittances (contributing over 20% of GDP), a narrow industrial base, limited export competitiveness, and heavy reliance on imports. The contribution of private final consumption expenditure (PFCE) in Nepal’s GDP is significant, generally constituting over 80% of GDP.

However, this high PFCE is not always a sign of strength; rather, it reflects limited savings and investment capacity in the economy. In contrast, gross capital formation (GCF), especially gross fixed capital formation (GFCF), has remained below 30% of GDP, reflecting Nepal’s under-investment in productive sectors.

Theoretical Perspectives

The theoretical justification is drawn from Keynes who, in his well-known General Theory, called for “a theory of demand and supply of output as a whole” (Keynes 1937) as compared to the orthodox theory, which held that supply creates its own demand (Say’s Law) and therefore no separate theory of output was required.

Keynes’s central argument was that investment was far more volatile than consumption, being dependent on the equilibrium of the marginal efficiency of capital and interest rate.

His contention was that aggregate demand may fall short of aggregate supply before it becomes vertical, signifying reaching full employment of resources. In that case, to drive the economy towards full employment, the interest rate may be lowered and investment increased, but this may not be sufficient if the demand for money becomes infinite and the economy gets caught in a “liquidity trap.”

 In that situation, markets fail to drive the economy to full employment equilibrium and the only solution is to raise the “effective demand” by raising the autonomous components of aggregate demand. In this context, government expenditure, assumed to be largely autonomous, can play a significant role. If autonomous, expenditure is increased, it impacts the output level by a multiple of the original increase due to the now well-known multiplier effect. In determining the magnitude of the multiplier, the “marginal propensity to consume” plays a critical role.

Keynes proposed what is now known as the absolute income hypothesis (AIH), which postulated that consumption expenditure (C) is primarily determined by the current level of absolute disposable income (Yd). His “fundamental psychological law” stated that as income increases, consumption also increases, but by a smaller amount.

This is often represented by a linear function: C=a+bYd, where “a” is the minimum amount of consumption expenditure, and “b,” is the marginal propensity to consume, which is equal to the change in consumption divided by the change in income in a given period and which is less than one. This minimum can be viewed as “autonomous.”

The presence of the minimum component implied that the average propensity to consume (APC), defined as C/ Yd, decreases as income rises. Since APC=(a/Yd)+b, as Yd increases, the term a/Yd diminishes, causing the APC to fall.

Keynes had proposed his theory essentially for short-term corrections for driving the aggregate demand to its full employment level. Its applicability for the long term was, however, challenged both on theoretical and empirical grounds.

Empirically, Kuznets, using long-run time series data, found that the APC remained relatively constant over long periods, contradicting the AIH’s prediction of a falling APC as national income grew. This discrepancy came to be known as the “Kuznets paradox.”

A number of alternative theories of consumption like Dusenberry’s (1949) relative income hypothesis, Friedman’s (1957) permanent income hypothesis, and Modigliani’s life-cycle hypothesis have been developed in the post-Keynesian literature. In the relative income hypothesis, Dusenberry argued that consumption is influenced by the income of an individual relative to his richer neighbors in the society (the demonstration effect), as also relative to his own past peak income, which makes his consumption sticky downwards (the Ratchet effect).

Friedman hypothesized that permanent consumption is a stable proportion (k) of permanent income: Cp=kYp. The factor k depends on factors like the interest rate, the ratio of non-human wealth to total wealth, and demographic factors, but not on the level of permanent income itself. Crucially, Friedman argued that there is little to no systematic relationship between transitory income and transitory consumption, or between transitory components and permanent components.

In the life-cycle hypothesis, current consumption, apart from the current disposable income, is also made a function of wealth and the current discounted value of expected income. These theories suggest that consumption is less sensitive to short-term income fluctuations than Keynes’s AIH implies.

In examining the applicability of these theoretical perspectives in Nepal’s current growth and stabilization context, we need to understand whether there are significant autonomous components in consumption expenditure as compared to other components of aggregate demand, such as private investment expenditure, and government (consumption and investment) expenditure. Further, there is a need to distinguish between the growths question from the stabilization question.

The growth question relates to determining potential growth consistent with full employment of resources. Keynes’s formulation was in a short-term context where technology and the availability of resources are given.

But in the longer-term perspective, technology improves productivity of factors and the availability of resources can also be augmented.

The stabilization question is; however, how best and quickly can policy intervention drive an economy operating below full employment level to its full employment potential.

In the latter case, the multipliers and the marginal propensity to consume do play a critical role. In substance, we need to point out that consumption is primarily a function of income and cannot be treated as autonomous. The autonomous element, if any, is limited. There is no lever to stimulate any autonomous element present in consumption.

If consumption expenditure is to expand during a short period, we have to act on the levers to raise income, say by reducing the tax rate, so that disposable income increases, facilitating higher consumption. Thus, if aggregate demand is weakening, the two levers to operate are government expenditure and investment expenditure.

Empirical Perspectives

Nepal, national account data from the Central Bureau of Statistics (CBS) shows that PFCE accounts for over 85% of GDP, while GFCF fluctuates between 25% and 30%. Government Final Consumption Expenditure (GFCE) remains around 10%. The investment-to-GDP ratio, though improving marginally due to public infrastructure projects, remains inadequate to drive transformative growth.

Public and private investment is hampered by bureaucratic inefficiency, political instability, and limited access to credit. Despite government efforts through the annual budget to increase capital expenditure, actual spending often falls short due to procurement delays and lack of institutional capacity.

In terms of stability, investment expenditures in Nepal are more volatile compared to consumption, which remains consistently high due to remittances. This makes private investment and government capital spending more viable instruments for counter-cyclical fiscal policy.

The Nepalese economy has evolved to be totally dependent on domestic demand. For analyzing long-term growth prospects, we have to look at the profile of gross fixed capital formation and convert it into GDP growth by using gross incremental capital output ratio (GICOR).

In the economic planning, the focus is on investment. The plan documents indicated the total investment to be made in the five-year period and, using an ICOR, which is estimated on the basis of the investment pattern, derived the growth rate. In the growth process, investment calls the shots.

 Obviously, rising consumption expenditure will stimulate investment. This is implicit in the “acceleration” principle. There is a certain circulatory reasoning here. But consumption expenditure per se depends on income, current or permanent. An investment-led growth strategy is the best choice for us. For stabilization or short-term stimulation, government expenditure still holds the key.

Strategic Way Forward

So in order to move towards a sustainable growth trajectory, Nepal must rebalance its economic model. For that Nepal should promote productive investment and both public and private sectors should prioritize investment in agriculture, manufacturing, tourism, and energy.

Furthermore, improving capital expenditure efficiency is necessary and for that reducing procurement hurdles, ensuring budget disbursement discipline, and enhancing project monitoring are essential. To strengthen Nepal’s economic foundation, it is essential to focus on boosting domestic savings, leveraging remittances, and enhancing policy implementation.

Promoting financial inclusion and offering incentives for long-term savings can play a critical role in mobilizing internal resources, reducing reliance on foreign aid and debt. Additionally, channeling remittances into productive sectors is crucial. This can be achieved by introducing innovative instruments such as diaspora bonds, supporting investments in cooperatives, and establishing remittance-backed infrastructure funds, which shift the focus from mere consumption to nation-building investments.

Equally important is the need to strengthen policy implementation through greater political commitment and institutional reforms, ensuring that development plans and investment strategies are effectively translated into tangible economic outcomes.

Structural Reforms

While consumption plays a dominant role in Nepal’s GDP, its dependence on external income flows makes it vulnerable. For long-term growth and economic stability, Nepal must shift towards an investment-led strategy, supported by sound fiscal policy and structural reforms.

Public investment, when managed efficiently, can crowd in private investment and create a multiplier effect that drives income, employment, and ultimately, inclusive development.