Journal Issue
IMF Working Paper Summaries (WP/95/1 - WP/95/61)

Summary of WP/95/8: “Inflation and Stabilization in Transition Economies: A Comparison with Market Economies”

International Monetary Fund
Published Date:
August 1995
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This paper examines inflationary pressures and stabilization in transition economies, and compares them with the experience of high-inflation market economies. A basic message of the paper Is that to understand the inflationary pressures experienced on the road to a market economy, it is essential to analyze the inherent nominal instabilities of planned economies. To that effect, the paper develops a simple monetary model to provide insights into the sources of inflationary pressures in planned economies. It is argued that the use of two nominal anchors (prices and wages) leads to an “overdetermination” of the system. As a result, a temporary increase in nominal wages relative to their planned values generates a permanent increase in the money supply and a permanent monetary overhang. Analogously, a permanent increase in the level of nominal wages causes an ever-increasing money supply and, therefore, an ever-increasing monetary overhang. The model also suggests that if prices are freed, the price level will overshoot its new equilibrium level.

Bearing in mind the themes suggested by the analytical model, the paper then discusses the evidence on inflation and stabilization in transition economies during 1990-93. The analysis makes clear that, in the transition to a market economy, centralized wage controls that had provided a nominal anchor in the past ceased to perform that function. At the same time, transition economies inherited the state enterprises’ soft budget constraints and lacked the indirect monetary instruments necessary to control the money supply effectively. In essence, therefore, one can think of the inflationary problems experienced by transition economies as resulting from their having abandoned the two nominal anchors of the previous regime (prices and wages) without being able to implement a monetary anchor. Under these circumstances, and provided enough international reserves are available, countries that have resorted to an exchange rate anchor have fared better on the inflation front.

The paper concludes that, despite significant differences in economic structures and institutional frameworks, the inflation and stabilization experiences of transition and market economies are similar in many respects. In particular, monetary accommodation and lack of fiscal discipline are critical in sustaining inflation, and exchange-rate-based anchors seem more successful than money anchors in bringing down inflation. However, wage policies appear to be more critical in reigning in inflation in transition economies than in market economies.

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