In this thesis, we study the causes of inflation in Mongolia. We estimate a small open economy VAR model for Mongolia. The model comprises of two blocks - China and Mongolia and we impose a block exogeneity restriction in regards with our estimation purpose. We assess domestic and external shock affect on price level of Mongolia using impulse response function and reveal the main contributors to the price variability utilizing the forecast error variance decomposition (FEVD). Therefore, we trace out that the external shocks affect the price significantly in comparison with the domestic shock. In addition, we can say that the price level is very susceptible under the supply side shock.