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IMF Working Paper: Sizable changes in relative goods prices during transition partly explain Albania’s low inflation

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International Monetary Fund. External Relations Dept.
Published Date:
January 2001
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Inflation during transition

After Albania embarked on reforms to transform its centrally planned economy into a market-driven one, inflation initially jumped to more than 200 percent in 1992, largely because the prices of a number of goods in the consumption basket were freed. Subsequently, Rother says, “inflation declined steadily and rapidly in an environment of strong economic growth and macroeconomic stability” and, by 1995, had dropped to less than 8 percent. In 1996, however, inflation surged again as the general elections and the rise of pyramid schemes (see IMF Survey, November 8, 1999, page 366) led to both political and social turmoil. The pyramid schemes collapsed in 1997, Rother notes, and the authorities managed to regain control over economic conditions in the second half of that year by implementing strong stabilization policies, including monetary tightening. Inflation declined to about 20 percent in 1998 and prices were essentially stable by 1999.

These low rates, Rother says, can be explained partly by the structure of Albania’s real sector, which is dominated by agriculture. After the collapse of centralized economic planning, agricultural assets were privatized quickly, providing most rural families with their own production base. As a result of privatization and price liberalization, agricultural output improved, helping contain the effect of a monetary overhang (an excess accumulation of savings). Also, Rother notes, labor costs became flexible because most farmers were self-employed. In contrast, Albania’s industrial sector was smaller and external trade relations were limited, features that spared the country from having to reallocate and support a large number of workers.

While inflation behavior in Albania can be explained partly by structural factors and monetary and fiscal policies, Rother says, it can also be explained partly by the sizable changes made in the relative prices of individual goods during the country’s transition. He notes that menu costs—the costs to firms of changing their prices—motivate firms to make price adjustments in response to shocks in an asymmetric fashion, with more upward than downward changes, which in turn drives up inflation in the short run.

Role of shocks

Rother describes two possible scenarios that would lead to asymmetric relative price adjustments: one in which underlying shocks to the economy are symmetric (that is, they drive the costs of some goods up and others down by an equal amount), and the other where the shocks themselves are asymmetric, driving some costs up without an offsetting reaction in other goods.

When shocks are symmetric, they trigger inflation only in an environment of positive trend inflation. In this scenario, Rother explains, relative price adjustments in response to the symmetric shocks are generally positively skewed; that is, there are more large positive changes than large negative ones. This is because suppliers who want to lower their relative prices tend to maintain the nominal prices, while price increases must also account for the inflation rate and are thus larger than they would be without trend inflation.

When the shocks are asymmetric, in contrast, relative price adjustments will affect inflation regardless of whether prices in general are increasing. In particular, Rother says, asymmetric relative cost increases will tend to spur inflation because large increases in a few prices are not offset by small declines in many prices, as a small adjustment is too costly in view of the menu costs. A typical example of a one-off asymmetric shock is an oil price increase that leads to a higher price level because non-oil prices are not lowered. The reverse holds for asymmetric reductions in costs.

In transition countries, substantial shocks are likely to occur because the shift from a centrally planned to a market-driven economy causes a total rearrangement of economic relationships and requires a new structure of relative prices. Sometimes, the necessary changes are symmetric, but asymmetric shocks are also likely to happen continuously. They may happen, in particular, for the following reasons:

In transition countries, substantial shocks are likely to occur because the shift from a centrally planned to a market-driven economy causes a total rearrangement of economic relationships and requires anew structure of relative prices.

• The relative prices for capital-intensive services such as housing may increase slowly from the depressed levels that prevailed under central planning, triggering a sequence of price hikes.

• The relative wages of highly skilled workers may be slow to converge to their equilibrium level, causing corresponding gradual adjustments in the relative prices of skill-intensive goods and services.

• Measured prices may be insufficiently adjusted for quality improvements, so that observed relative price changes exceed actual changes.

• The relative prices of nontradable goods and services may rise if productivity gains in that sector fall behind those in the traded goods sector (the Balassa-Samuelson effect).

In the first case above, Rother notes, it may be optimal for relative prices of capital-intensive services to adjust slowly during transition because countries embarking on market reforms have a large capital stock (for example, in the form of housing) relative to their per capita income and no associated debt. Thus, he explains, it might be desirable for the prices of services to be set initially to recover only current costs while allowing the capital stock to depreciate to a level in line with income. As incomes rise, prices gradually rise to cover depreciation and the cost of capital.

In the case of wages, relative adjustments between skilled and unskilled workers may induce a similar gradual shift in relative prices. Under central planning, skilled workers earned only slightly more than unskilled workers, and the opening of the economy caused real wages to converge to market-determined levels. Despite a shortage of empirical evidence for Albania, Rother concludes on the basis of evidence from other transition countries that the wages of skilled workers rose rather than that those of unskilled workers declined. He also concluded that wage changes were driven by newly established enterprises. Thus, he says, “the slow emergence of new private enterprises in Albania suggests that the adjustment of the wage structure has evolved only gradually over time, inducing a sequence of wage shocks to the economy.”

Looking at the evidence of individual price changes during Albania’s transition to a market economy, Rother notes substantive relative price adjustments. Between 1994 and 1999, cumulative inflation of the Albanian unweighted consumer price index basket (containing 221 items grouped into 8 categories) amounted to 123 percent, with price changes of individual items varying from declines of 12 percent (for satellite dishes) to increases of more than 900 percent (for grapes). In addition, he found that the price adjustments were indeed positively skewed so that, in line with the theory, they may have contributed to overall inflation. The inflationary impact of asymmetric relative price adjustments was supported by an econometric analysis, where the skewness of relative price changes was found to affect the inflation rate positively.

Inflation in Albania and transition economies

annual average in percent

1 Transition economies with annual inflation below 1,000 percent during transition: Czech Republic, Estonia, Hungary, Kyrgyz Republic, Latvia, Lithuania, Mongolia, Poland, Romania, Slovak Republic, and Slovenia.

Data: IMF, Working Paper No. 00/207

Implications for monetary policy

Rother concludes that the continued need for relative price adjustments has put upward pressure on inflation. The effect of such adjustments on inflation is large enough to be economically meaningful and is likely to persist, he says. In his view, policymakers must decide the extent to which monetary policy should accommodate the inflationary impact of asymmetric price increases. This will involve weighing the trade-off between the risks of inducing inflationary expectations in the economy and the costs of disinflation when inflation is already low.

For Albania, Rother says, the optimal rate of inflation is probably higher than the level—generally around 2 percent–that developed countries usually aim for. He suggests that an inflation target of about 3 percent should be sufficient to allow for the necessary price changes without exceeding the threshold (about 5 percent) above which inflation is likely to harm the economy.

Copies of Working Paper No. 00/207, Inflation in Albania, by Philipp C. Rother, are available for $10 each from IMF Publication Services. See page 98 for ordering information.

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