Tight monetary and credit policies have been a cornerstone of the economic policies followed in all three Baltic countries since the adoption of their stabilization and reform programs in mid-1992. These policies have been supported by controlled fiscal outcomes and have yielded stability in the exchange rates of the newly introduced currencies. Inflation has also fallen sharply from the high rates experienced in 1992, However, price increases remain high by industrial country standards, averaging 2 to 3 percent a month in late 1994 and early 1995.
This paper discusses the factors behind this continued high inflation. It is argued that the initial undervaluation of the new currencies is a significant cause of the recent inflation. The initial undervaluation relative to fundamentals may have been due to a range of asset market considerations including risk, incomplete markets and legal arrangements, imperfect information, and the irreversibility of investment. Evidence for the undervaluation of the real exchange rate can be found in price surveys, which suggest that the general price level may be far lower than in industrial countries and lower than would be normal for countries with income levels similar to those of the Baltics.
As the initial real exchange rate undervaluation is eliminated, and growth picks up, inflation in the Baltics is likely to be driven mainly by structural factors related to differential growth rates in the tradable and nontradable sectors. The standard two-sector model of Balassa and others suggests that the tendency for productivity growth to be faster in the tradables sector will result in increases in the relative price of nontradables and an appreciation of the real exchange rate. These effects may be quite important in countries that experience high growth rates, and they would imply that the real appreciation in the Baltics may be a sustained phenomenon.
A simple scenario is presented to shed light on the possible evolution of prices and incomes in coming years. The likelihood of continuing real appreciation implies that it will not, in general, be possible to target both the exchange rate and the price level at the same time. In particular, given an undervalued real exchange rate and a fixed nominal exchange rate, a restrained credit policy in itself will not bring about low inflation outcomes, since balance of payments inflows will lead to monetary growth and price increases. Alternatively, if price stability is targeted, it may be necessary to allow for periodic nominal revaluations.