MacrostabilizationMacrostabilization

Economics of TransitionEconomics of Transition

MacrostabilizationMacrostabilization

At the very beginning there might be a problem of hyperinflation (50% monthly inflation rate or more), when old system is defunct and new instruments are not yet in operation

Causes of inflationCauses of inflation

Monetary overhang:

Cannot be really thought of as a source of ongoing inflation, only as the reason for the initial price jump.

Continued inflation has other sources (see below; maybe those sources are underestimated by economic policy maker => continued strong inflationary pressure)

Causes of inflation cont.Causes of inflation cont.

Monetary overhang and forced savings is not a micro issue, rather a macro issue in the sense that an individual might be able to spend all his/her wages.

On the macro level thoughsum of wages > nominal value of sum of wages > nominal value of

supply of consumption goodssupply of consumption goods

Causes of inflation cont.Causes of inflation cont.

In the 60’s willingness to save,

dy/dt. >> 0, since workers had hope of future consumption goods.

With stagnation (80’s), length of queues => people are now forced to save.

Causes of inflation cont.Causes of inflation cont.

Towards the end of socialist regimes, worker’s position got stronger, large wage hike in tandem with immanent price liberalization => queues =>

forced savings

(the longer the queue, the less is my chance to obtain a good => the more I have to save)

Forecasts Forecasts of corrective inflation of corrective inflation due to due to monetary overhang.monetary overhang.

Fischer’s equation

V*M = P*Q, taking logs {dLn(P) = dP/P}

v + m = p + q, where v = log(V) etc.

p = v + m – q

p = v + m - q

(=0) (=0) in the short run

 

=> p depends on my estimate of v.

ForecastsForecasts of corrective inflation of corrective inflation due to due to monetary overhangmonetary overhang cont. cont. p was wrongly forecasted by western

models, because v was very wrongly predicted.

Sophisticated western models, which use savings ratio, i.e. M3 to demand deposits M2, could not be sensibly used in TE’s to forecast v.

Households have three assets: cash, savings and foreign currency.

Ways to get rid of monetary Ways to get rid of monetary overhang:overhang:

Note: one would like to minimize monetary overhang, to minimize corrective inflation, which has an impact on inflation in the medium run given the political economy of transition.

In a nutshell getting rid of monetary overhang => reducing liquidity by partial or total confiscation of the money stock.

Ways to get rid of monetary Ways to get rid of monetary overhang cont.overhang cont.

● German currency reform (1948) amounted to a total confiscation: when there is a political support for such a reform, one might have to establish a costly social safety net;

partial confiscation was tried under Ryzkov government in the SU (1991) with a strong backlash leading to August coup of the same year.

Ways to get rid of monetary Ways to get rid of monetary overhang cont.overhang cont.● Achieve reduction in liquidity by

offering good conditions to savers, i.e. offer high real interest rates.

Problem with this approach is that at the beginning of transition banks are state owned => savings deposits are public debt and interest payments = servicing public debt.

Before currency reform in Germany an interest rate of 2-3% => 10-15% of GDP!

Ways to get rid of monetary Ways to get rid of monetary overhang cont.overhang cont.

The way monetary overhang was dealt with in the end was to do nothing in terms of direct measures;

just liberalize prices and get an implicit confiscation of the overhang.

Ways to get rid of monetary Ways to get rid of monetary overhang cont.overhang cont.

A B

Q

D

S

P

P0

Pe

Ways to get rid of monetary Ways to get rid of monetary overhang cont.overhang cont.Pe-P0 represents corrective inflation in

the depicted market (just a picture, does not address issue of output fall, which is indicated by broken line).

More realistic to think about B than A

(Causes for output contraction see below)

Ingredients of Ingredients of macrostabilization:macrostabilization:(Polish plan as an example): strong BB

version

1) Price liberalization and trade liberalization (removes disequilibria, generating initially corrective inflation,

130% in January 1990;

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:trade liberalization => foreign

competition => keeping down price rises by domestic firms who initially operate in a very monopolistic market structure (recall large size bias of firms under socialism)

Note, not all prices were immediately fully liberalized, staple foods and energy prices were still “administered”

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:2) Monetary policy: allowing only a very

moderate growth rate of money supply:

M*V = P*Q => m +v = p +q =>

p = m + v – q => dp = dm +dv – dq;

clearly dm has an impact on dp.

Balcerowicz government tried to keep growth rate consistently low, but there was tremendous pressure to loosen monetary policy (e.g. from solidarity trade union side)

Ingredients of Ingredients of macrostabilization cont.:macrostabilization cont.:3) Fiscal policy, slashing subsidies to

SOE’s (has also the indirect effect of improving behaviour by managers of SOE’s) direct effect expenditures.

Upshot keep fiscal deficit at a minimum, especially since deficit can only be monetized in early days of transition (i.e. can only be covered by printing money).

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:4)  Exchange rate as a nominal

anchor

P = *e*Pw + (1- )*Pd

Pw - constant world prices

Pd – domestic prices

e – nominal exchange rate, i.e. Zloty/$

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:Keeping e relatively fixed will prevent

imports having a destabilizing effect on overall price level;

IMF provided a loan of 1bn US$ to defend the exchange rate (foreign reserves might be easily exhausted and exchange rate cannot be credibly defended).

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:

Dus$

Amount of $

$/ru

$/ru

Sus$

Foreign exchange market

E.g.↑ Speculation => ↑ demand for $ => CB of Russia needs to ↑ Sus$ to keep e constant

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:In the first year this loan was not needed as

IMF’s guarantee was credible and there was no currency speculation against Zloty.

5) “Incomes policy”, better a tax on excessive wage growth.

Assume prices are a mark-up on wages,

i.e. P*(Q/L) = *W where is constant

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:W = P*(Q/L)*(1/)

p• = dp/dt and p = log(P)

p + (q - l) = log () + w

p• + (q• - l•) = w• => p• = w - (q• – l•) where

p• – inflation (growth rate of prices)

w• – growth rate of nominal wages

q• – l• growth rate of labour productivity

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:p• = 0 as long as w• = q• – l•, i.e. as long as

nominal wage growth is equal to growth rate of labour productivity.

In Poland, a tax on wage growth was imposed that demanded initially a 100% penalty if w• > q• – l•

Relatively successful, although some firms were willing to pay penalties in the first year.

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:Important point about macro policies: in

Polish case (but also in Gaidar’s Russia) they were thought of “whipping firms into the proper micro behaviour”, i.e. with subsidies taken away, with no longer easy credit, (m•0), and with foreign competition present, SOE’s would become rational agents at micro level, so no micro management was required even in case of SOE’s.

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:Most TE’s have tried some variant of

Polish case two main exceptions: Estonia since 1993 and Bulgaria since the late 90’s have adopted a currency board approach to price stabilization: growth of money supply is strictly tied to growth of foreign reserves, linking the domestic currency effectively to the mark/EURO

Ingredients of Ingredients of macrostabilization cont:macrostabilization cont:How successful were the stabilization

effects? In CE some persistent inflationary

pressures in the first years that have, however, subsided. In CIS these pressures were stronger and more persistent throughout the nineties.

To understand these divergent trends we need to look at potential causes of persistent inflation.

Sources of destabilizationSources of destabilization

Pre-reform: government is weak, w => budget deficit which is monetized => p => weak government again w: wage-price spiral.

Classic example: Poland 1989 p• = 251.1%

3 immediate problems (not only immediate in CIS)

Sources of destabilization cont.Sources of destabilization cont.

1) Enterprises don’t accept hard budget constraints, i.e. they don’t accept removal of soft budget constraints.

2) Workers don’t accept w/p that comes about with price liberalization and want w•>q• - l•

3) Fiscal deficit profit taxes (tax revenues in general after tax reforms)

Sources of destabilization cont.Sources of destabilization cont.

Ad (1) Inter-enterprise arrears => problems with enforcing tax payments e.g.

Some have argued though that IEA were not really that large in the international prospective, e.g. Mark Schaffer

Sources of destabilization cont.Sources of destabilization cont.

Ad (3) Are SOE’s a major block to fiscal stabilization?

Government gives up its property rights and at least initially no explicit tax collection system => hard to collect taxes.

Sources of destabilization cont.Sources of destabilization cont.

=> Fall in revenues => pressure to decrease expenditures (subsidies to firms)

=> pressure by local governments on banks to give credit to local enterprises which produce local infrastructure (=> revenues for local governments), but large cheap credits undermine monetary policy.

Sources of destabilization cont.Sources of destabilization cont.

Contrast Poland/Russia to point to the crucial role of enterprises in tandem with monetary policy:

PolandPoland RussiaRussia

After one year hard budget constraint imposed

Tight monetary policy, i.e. relatively small credit expansion and strong discipline in banking sector

Soft budget constraint pervasive

Relatively lax monetary policy, i.e. easy access to credit for Russian SOE’s

Poland Poland RussiaRussia

=> Changes behaviour of managers

Inflationary pressures lessened after a while

Less change in behaviour

Inflationary pressures persistent

Sources of destabilization cont.Sources of destabilization cont.

There is also some pressure to ↑e, i.e. to devaluate exchange rate, as P•

w << P•d, the

real exchange rate, e/(P•w/P•

d) ↑, i.e.

domestic firms become less competitive in world markets, pressure builds up to devaluate => impact on inflation.

Overall though, (1) and (3) are the most important factors in explaining better performance of CE over CIS.