Jonathan Anderson and Daniel A. Citrin

Jonathan Anderson and Daniel A. Citrin

This section examines the behavior of inflation and broad money velocity in the Baltic countries, Russia, and other states of the former Soviet Union during the transition period to early 1995.1 Over the 1992-94 period as a whole, the path of inflation has closely tracked the growth rate of monetary aggregates. In many states, however, concern has been growing over the substantial increases in velocity and declining levels of real money balances, which have been reflected in intervals of strong divergence between rates of inflation and monetary expansion. Proposed explanations for these inflation and velocity movements have included “crises of confidence” in the domestic currency as well as independent inflationary pressures due to import price increases or domestic price liberalization.

Of particular interest here is whether movements in real money balances and velocity have been driven by shifts in the underlying demand for real money holdings or by other factors. A review of the available data suggests that money demand movements have been important in some cases, but, for many countries, independent factors such as exogenous import price increases or adjustments in administered prices may have played a key role. Moreover, the response of inflation to changes in the stance of monetary policy has often been slow.

For those countries that experienced large increases in velocity and declines in real money balances, subsequent reversals have been achieved through firm tightening of monetary policies and establishing positive real rates of return on domestic monetary assets. These policies reduced inflation and led to an eventual increase in confidence and rising demand for real balances. Containing wage pressures may also have facilitated reductions in velocity, as countries where initial inflationary shocks fed into a cycle of high wage growth experienced greater difficulty in controlling inflation and restoring confidence.

The behavior of inflation and velocity in the region since 1992 is reviewed, with particular emphasis on the role of velocity movements in stabilization efforts under Fund-supported programs. Possible explanations are then given for the observed increases in velocity as well as the diverging performance in various countries. A discussion on policy responses to inflationary and money demand shocks follows, with a review of country experiences in achieving subsequent recovery in real money balances. Finally, lessons and implications for future stabilization efforts are discussed.

Behavior of Money, Income, and Prices, 1992–94

The inflation experience of the Baltics, Russia, and other states of the former Soviet Union for the April 1992 to September 1994 period is presented in Tables 3.1 and 3.2. 2 Countries fall into three basic categories: the first, comprising the Baltic states, suffered high inflation early on but then succeeded in stabilizing over the course of 1993. The Kyrgyz Republic, Moldova, and Russia form a second group where inflation was brought under (at least) moderate control during the first three quarters of 1994.3 The remaining countries have been characterized by very high and often unstable rates of price increases, and stabilization continues to be a priority.

Table 3.1.

The Baltics, Russia, and Other Countries of the Former Soviet Union: Money and Prices, 1992-941

(Average monthly percent changes)

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Sources: Data provided by country authorities; and IMF staff estimates.

Inflation, money, and velocity growth are calculated for the period from the second quarter of 1992 through the third quarter of 1994; velocity is defined on the basis of real GDP and retail price movements.

For Azerbaijan, Georgia, Tajikistan, and Turkmenistan, because quarterly data on real GDP are not fully available, changes in velocity are proxied by rates of decline of real money balances.

Table 3.2.

The Baltics, Russia, and Other Countries of the Former Soviet Union: Quarterly Changes in Macroeconomic Variables1

(Percentage changes within the quarter)

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Sources: Data provided by country authorities; and IMF staff estimates.

Broad money refers to domestic currency M2; velocity is defined as an index based on the methodology described on page 45, footnote 5.

The behavior of inflation is related to that of the other macroeconomic variables in Table 3.1 on the basis of a standard Fisher equation, whereby,4


with P equal to the consumer price index, M to domestic broad money (i.e., exclusive of foreign currency holdings; the role of the latter is discussed further below), V to velocity of broad money, Y to real GDP, and a “.” over a variable indicating its rate of change.5

Data for the two-and-a-half year period as a whole confirm that inflation in the region has been primarily a monetary phenomenon; inflation has been strongly correlated with the rate of monetary expansion in every country. As a group, the Baltic states registered both the lowest rates of broad money growth over the period (average monthly rate of 7 percent) and the lowest inflation (7 percent). The intermediate group, which experienced somewhat higher monthly inflation (16 percent), also recorded higher monetary expansion on average (13 percent). The remaining countries in the region on average recorded significantly higher monthly money growth (21 percent) and inflation (28 percent).

Over the period as a whole, changes in the velocity of broad money have, in general, been much smaller than those in prices and money (Table 3.1). Notably, velocity tended to be more stable the lower the inflation rates that were recorded. In the Baltic states, velocity was virtually unchanged on average, while in the intermediate inflation group, it rose at an average monthly rate of 1 1/2 percent during the period. In most high-inflation countries, velocity rose significantly—at an average monthly rate of 5 percent. In a few cases, the increases corresponded to extreme declines in the level of domestic real money balances. In Armenia and Georgia, for example, an average monthly increase of broad money velocity of 9 percent implied a decline in the real stock of broad money to a small fraction of the level in April 1992 by the end of the period (Table 3.3). Within this group, only in Uzbekistan was velocity roughly unchanged over the period.

Table 3.3.

Real Domestic Money Stocks, as of Third Quarter of 1994

(1992: Second quarter = 100)

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As of the first quarter of 1994.

An examination of quarterly data reveals a considerably greater degree of variability in the short-term relationship between money and prices. Differences of from 15 to 30 percentage points between average monthly rates of inflation and money growth may be observed in a number of countries.

Divergences in inflation and rates of monetary expansion have almost always been associated with corresponding movements in velocity (rather than large swings in output).6 Indeed, on a quarterly basis, changes in velocity have sometimes overwhelmed movements in money in their “explanatory power” over prices.

Of particular note is the fact that movements in real money balances and velocity have generally occurred not in smooth trends, but rather in large discrete shifts; moreover, bouts of high inflation and velocity growth occurred at approximately the same time across a number of countries. During late 1993 and early 1994, velocity rose substantially (often two- to threefold or more) in the space of one to two quarters in ten countries in the region, that is, all except for the Baltic states, Russia, and Uzbekistan (Chart 1.4).7 In most cases, these increases in velocity were associated with a substantial acceleration in inflation, for example, in Armenia, Georgia, Tajikistan, and Turkmenistan. Only in a few instances (e.g., the Kyrgyz Republic and Moldova) was the rise associated with stable inflation and a decline in the rate of monetary expansion.

Also of interest is the protracted nature of movements in velocity and real balances in many countries; in some, velocity has declined only slowly following the initial increase, while in others it has remained at its new, higher level. Only in Lithuania and Moldova have sharp swings in velocity and real balances been followed by a quick return to previous levels.

A review of the experience of Fund-supported programs further underscores the ability of money growth and inflation paths to diverge substantially in the short term. Table 1.4 shows the behavior of money, prices, and velocity under 13 arrangements (and several Fund facilities) in eight different countries in the region.8 In most cases, inflation outcomes under stabilization programs exceeded program targets by wide margins, with the rate of inflation either remaining high or even accelerating during the program period. The only initial stabilization programs whose inflation targets were met or close to being met were the stand-by arrangements for Estonia and Latvia (both introduced in August 1992); in the Kyrgyz Republic, Moldova, and Lithuania, inflation was reduced as envisaged under follow-up arrangements, but the first attempts at stabilization failed.9

In five of the seven stabilization programs where price objectives were not attained—Belarus, Kazakhstan (1993), Kyrgyz Republic, Lithuania, and Moldova—higher-than-expected inflation occurred in the face of much lower contemporaneous rates of broad money growth and reflected marked and unanticipated increases in velocity. In Kazakstan (1994), the poor inflation outcome was associated with both excessive monetary expansion and an unanticipated rise in velocity. Only in Russia (1993) was the poor inflation outturn mainly associated with similarly high levels of monetary expansion.

Indeed, the behavior of inflation and velocity contrasted sharply to program projections. While the programs generally recognized that inflation would not respond immediately to monetary tightening, and thus projected a rise in the velocity of broad money in the first quarter of the program, velocity was subsequently expected to remain broadly stable or to decline.10 The projections for real money balances beyond the initial period were even smoother, as velocity was generally projected to offset seasonal fluctuations in output. In the event, velocity rose and real balances fell sharply for several quarters in almost all of the cases where stabilization was not achieved.

Explaining Inflation and Velocity Movements

We now turn to examining the possible factors underlying the observed behavior of inflation and velocity. Here the focus is on those periods when large shifts in velocity and real balances and velocity occurred, then the subsequent path of velocity and money in the region is examined. The analysis is based on a standard aggregate demand and supply framework that provides a general depiction of the short- and long-term determinants of the rate of inflation.11 Under such a framework, the rate of monetary expansion determines the rate of inflation in long-run equilibrium. In the short run, however, inflation can depend on a number of other factors, giving rise to fluctuations in real money balances and the velocity of broad money. First, inflation may simply have an inertial component, resulting in a lagged response of prices to changes in monetary expansion. Second, changes in the demand for money due, for example, to changes in its underlying determinants (e.g., a rise in inflationary expectations) will be reflected in movements in the velocity of broad money (i.e., short-run deviations in inflation relative to the rate of monetary expansion). Third, factors such as lax wage policies, exogenous import price increases and changes in domestic relative prices owing to changes in administered prices can put upward pressure on prices and lead to diverging paths of inflation and money growth in the short run. Finally, observed differences in the paths of inflation and monetary expansion can reflect improper measurement of one or both of the variables.

Inflation and Rate of Growth of Broad Money

The lack of contemporaneous correlation between money and price movements is likely to reflect—at least in part—the lagged response of inflation to changes in the rate of monetary expansion. Lags in the response of inflation to changes in financial policies are common in all economies; a particular contributing factor in the Baltics, Russia, and other states of the former Soviet Union has almost certainly been the high volatility of money growth. In many countries, growth rates of the monetary aggregates have varied at times by up to 50 percentage points or more on a month-to-month basis. Under such conditions, the short-term behavior of monetary aggregates may provide little information as to underlying trends. Thus, not only will price and wage expectations be likely to be based, at least partly, on the past behavior of inflation, but expectations of the future stance of monetary policy are likely to react slowly to shifts in the observed rates of money growth.

Accordingly, changes in the rate of monetary expansion would generally result first in short-term fluctuations in real money balances and velocity, and only subsequently in changes in the rate of inflation. This has likely been particularly true under stabilization efforts, which envision often dramatic changes in the path of money growth; a significant monetary tightening might not be perceived (or be considered credible) until well into the stabilization program. Allowing for lags in the response of inflation to money growth does seem to yield a “good fit” in the observed relationship for a few countries—in particular, for Latvia, Moldova, and Russia (Chart 1.6). In these countries, inflation appears to have closely followed broad money growth with a lag of roughly one quarter.12

For most other countries, however—in particular, Armenia, Azerbaijan, Belarus, Georgia, Kazakstan, and Turkmenistan—intervals of strong divergence in the growth rates of money and prices remain even after accounting for such lags. Moreover, although the growth rates of prices and broad money have tended to converge following such periods of sharp differences, the effects of the previous deviations on velocity have not been reversed.13 Instead, as noted above, the sharp increases in velocity registered in the latter half of 1993 generally were not followed by corresponding declines in 1994, with the exception of Moldova and to a lesser extent Ukraine.

Thus, for many of the countries in the region, prices appear to have responded to factors other than changes in monetary policy in the short run. In that regard, possible explanations are changes in the demand for real money balances, as well as exogenous movements in the exchange rate, wages, the terms of trade, and administered prices. These factors are examined below.

Factors Affecting the Underlying Demand for Money

Inflationary pressure not related to changes in monetary policy may be caused by an exogenous decrease in the underlying demand for real money balances (i.e., a shift in the demand curve)—related, for example, to a loss of confidence in the domestic currency. The demand for real money balances is specified as a standard function of the relative rate of return to domestic monetary assets as compared with other assets ρ, the level of real activity (Y), and a shift parameter (ψ) that acts as a proxy for such factors as changes in the level of uncertainty regarding the future relative return to monetary assets, or changes in the internal or external convertibility of domestic money. The relative rate of return to domestic money is defined as the nominal rate of return (i)—equal to the deposit rate of interest for non-cash holdings and zero for cash holdings—less either the return to domestic real assets (proxied by the rate of inflation, π) or the return to foreign monetary assets (proxied by the rate of nominal exchange rate depreciation, ė). With the relative underdevelopment of domestic bond markets in these countries, it is assumed that there are no alternative domestic financial assets. Thus,


From this money demand function and the Fisher equation shown above, an equation for velocity as a function of the determinants of money demand may be derived.

Movement out of domestic monetary assets can have an impact on the price level both indirectly, as capital flight leads to exchange rate depreciation, and directly through precautionary goods hoarding.

The observed relationship between real balances and real interest rates for countries in the region tends to support the role of money demand shifts in explaining inflation and velocity movements. An exogenous decline in the demand for real money balances would be expected to put upward pressure on the rate of return on domestic monetary assets.14 And, indeed, by plotting movements of the real money stock together with those of the real interest rate, it would appear that, for the region as a whole, large swings in real balances have been accompanied by inverse movements in the rate of return on monetary assets (Chart 3.1).15 In particular, for each of the ten countries that recorded large increases in velocity in late 1993 and early 1994, declines in real money balances were associated with increases in the observed real interest rate.

Chart 3.1.
Chart 3.1.
Chart 3.1.

Relative Interest Rates and Real Balances

(Left scale: real interest rate; right scale: real balances)

Sources: Data provided by country authorities; and IMF staff estimates.Note: Real interest rate is the central bank refinance rate minus three-month moving average consumer price inflation; real money stock is the real domestic stock of broad money (April 1992 = 1).1The real interest rate is calculated using commercial three-month interest rates.

Other evidence, however, is less supportive of the role of money-demand shocks. First, while for a few countries it is easy to point to direct factors that could have caused a decline in real money demand, for most others there is no obvious explanation. For example, the introduction of national currencies could easily have led to a crisis of confidence, particularly if there were no strong signals as to the future stance of monetary policy. In fact, in Armenia and Turkmenistan, and to some extent in Kazakstan, the acceleration in inflation and rise in velocity at the end of 1993 occurred at roughly the same time as the introduction of new national currencies. Other states, however, introduced new currencies with no effect on velocity (Estonia, Latvia, Uzbekistan), or registered significant velocity movements either much earlier or much later than the currency reform (Azerbaijan, Belarus, Kyrgyz Republic, Lithuania, Moldova, Ukraine).16

In addition, declining demand for domestic money does not appear to have reflected increasing inflationary expectations caused by earlier accelerations in monetary expansion.17 In fact, most of the ten countries that experienced bouts of strong inflation accompanied by velocity increases (Armenia, Azerbaijan, Belarus, Georgia, Kazakstan, Turkmenistan, and, to some extent, Ukraine) did so during periods when the rate of money growth had been roughly stable or falling for months (Chart 1.6).18

Finally, the relationship between inflation and exchange rate behavior in these countries does not suggest that shifts in money demand in favor of foreign currency were significant in explaining increases in inflation and velocity. As mentioned, money demand movements in favor of foreign currency would be expected to affect the rate of inflation through changes in the nominal exchange rate. If flight from domestic currency were the primary cause of inflation, however, then the rate of nominal exchange rate depreciation would be expected to be as high, or higher, than the inflation rate. In fact, an examination of the period from late 1993 to early 1994, when the rate of inflation in these countries was much higher than that of broad money growth, reveals that declining real money balances were associated with an appreciation of the real exchange rate (Chart 3.2).19 The main exception seems to be Georgia, where the real exchange rate depreciated dramatically as real balances fell in late 1993. (The evidence is very different for periods of decreasing velocity and rising real balances; these cases are discussed further below).

Chart 3.2.
Chart 3.2.
Chart 3.2.

Real Balances, Real Wages, and the Real Exchange Rate

Sources: Data provided by country authorities; and IMF staff estimates.Note: Real wage is the average wage deflated by retail price index; the real exchange rate is the nominal U.S. dollar exchange rate deflated by retail price index (+=depreciation).1Real wage calculated using minimum wage.

Thus, the broad evidence on the role of money demand shocks is mixed. While there are strong arguments in favor of money demand movements in a few country cases (Armenia, Georgia, Kazakstan, Turkmenistan), for the remaining countries no firm conclusions can be drawn.

Influence of Exogenous Factors

A third explanation for velocity movements relates to the role of exogenous price pressures, which can give rise to periods of high inflation not accompanied by corresponding increases in money growth.20 Exogenous changes in nominal wages—owing, for example, to adjustments in minimum wages or public sector wages that may not be directly linked to labor market conditions—could also have an independent influence on inflation. Here again, however, the aggregate data suggest that exogenous wage pressures generally were not an independent factor pushing up prices. As Chart 3.2 clearly indicates, when real balances fell markedly in the second half of 1993 and early 1994, real wages also declined in each of the ten relevant cases.

In contrast, exogenous increases in import prices appear to have a large impact on inflation in most of the ten states. For those that were importers of energy products, the primary external price shock has been the large increase in energy prices in intraregional trade between 1992 and 1994. In some cases, prices for energy products increased tenfold or more in U.S. dollar terms, and with the notable exception of the Baltic states, most of this jump appears to have occurred in the latter half of 1993 (Table 3.4).21 Another important factor for the region was imported inflation from Russia: the substantial rise in the real exchange rate of the Russian ruble against the U.S. dollar implied estimated increases of around 200 percent in the dollar prices of imports from Russia during the second half of 1993.22

Table 3.4.

Energy Import Prices

(In U.S. dollars)1

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Sources: Data provided by country authorities; and IMF staff estimates.

Unless otherwise noted.

In thousands of cubic meters.

The data shown for the first quarter are for the first half of the year.

Domestic price.

Price of imports from Russia.

Price of imports from Kazakstan.

Accordingly, these increases in external prices are likely to have made an important contribution to the rise in broad money velocity across much of the region in the latter part of 1993. For Estonia and Latvia, where energy import prices had already reached world levels by the middle of 1992, strong increases in velocity were not registered during the period covered in this paper. In Lithuania, energy prices rose dramatically during 1992 to reach world market levels; at the same time, the velocity of broad money rose by about three fourths.

In contrast, in Russia, the system of export quotas allowed domestic prices of energy to remain low in the face of marked increases in prices of energy exports. Furthermore, the real appreciation of the Russian ruble worked to dampen rather than add to underlying domestic inflationary pressures. This could help explain why in the case of Russia there was only a relatively small unanticipated increase in velocity.

Another independent influence on the short-term rate of inflation and velocity has likely been adjustments in administered prices. Available data indicate that in late 1993 Azerbaijan, Belarus, Georgia, Kazakstan, Moldova, Turkmenistan, and Ukraine all registered significant increases in domestic administered prices for food and energy products, and transport and communications services. In the absence of full downward flexibility of nonregulated prices, these increases in regulated prices—which ranged from two to ten times in a single month—tended to push up the overall price level beyond what would be implied by the rate of monetary expansion.23

Exogenous price movements, like those mentioned above, would be reflected only in temporary increases in inflation and velocity. If velocity rose because of exogenous short-term increases in inflation, then one would normally expect subsequent pressures for realignment in money markets and a recovery in real money balances. Thus, independent price shocks cannot of themselves explain the relative permanence of velocity movements in many states. However, independent price pressures could lead to more prolonged velocity movements if (1) initial shocks gave impetus to a cycle of further inflationary pressures, for example, through domestic wage movements, or (2) money market pressures were accommodated through the creation of informal liquidity. The possible role of wages in prolonging velocity swings is discussed later.

Role of Interenterprise Credit

If informal claims, such as interenterprise credits or arrears, are a sufficiently close substitute for banking system liquidity, then price movements will reflect not only the growth of monetary aggregates but also the creation of informal claims. In particular, periods of significant expansion in informal credits could be reflected in diverging rates of inflation and money growth and thus increases in observed velocity.24 The widespread presence of informal credit, moreover, could sustain a high level of nominal expenditures and thus extend the adjustment period, helping to explain the protracted nature of velocity movements in many countries in the region.

Indeed, there are strong indications that such credits have contributed to upward movements in velocity. For a number of countries for which a consistent time series exists—Azerbaijan, Belarus, the Kyrgyz Republic, Russia, and Ukraine—there is a rather striking relationship between the fall in real balances and the rise in interenterprise credits in late 1993 (Chart 3.3). Other countries (e.g., Moldova, Kazakstan, and Turkmenistan) have also reported large run-ups of informal credits and arrears during periods of falling real balances and rising money velocity.25

Chart 3.3.
Chart 3.3.

Real Balances and Interenterprise Credit

Sources: Data provided by country authorities; and IMF staff estimates.Note: The real money stock is the three-month moving average growth rate of real domestic broad money stock; informal credit is the three-month moving average growth rate of interenterprise credit (series smoothed to exclude effects of netting operations).

Measurement Errors

A final explanation for the observed velocity movements in the region would be errors in measuring both money and price movements. With regard to the money stock, prior to the introduction of national currencies, official monetary statistics were based on officially reported shipments of cash rubles from Russia and excluded unrecorded interstate flows of pre-1993 cash rubles that may have altered the true magnitude of cash in circulation. In the event, a number of states that still accepted pre-1993 cash rubles as legal tender in the fall of 1993 experienced inflows of these notes as neighboring countries moved to national currencies. In most cases, these inflows are not likely to have had a significant impact. In a few instances, however, they may have been quite substantial. Armenia and Tajikistan, in particular, reported large inflows during the last two months of 1993, as most of their neighbors introduced their own currencies; these inflows are likely to have contributed significantly to a 500 percent increase in the price level in November in Armenia and a 200 percent rise in December in Tajikistan.

Measuring velocity movements using the domestic money stock would also create distortions if there were significant currency substitution, that is, flight to foreign currency holdings for use both as an asset and for transactions purposes. While data on foreign currency holdings are notoriously sketchy,26 their inclusion in the definition of broad money does reduce somewhat the magnitude of observed velocity swings for a few countries (such as Belarus and Georgia; see Chart 3.4). However, the effect is not nearly large enough to explain the entire change in velocity. And for most other countries, the inclusion of foreign currency provides little additional explanatory power.

Chart 3.4.
Chart 3.4.
Chart 3.4.

Broad Honey Velocity Including Foreign Currency

Sources: Data provided by country authorities; and IMF staff estimates.Note: Velocity is domestic broad money velocity, index (April 1992 = 1). Velocity including foreign exchange is total broad money velocity including foreign currency deposits, index (April 1992 = 1).1Velocity is defined as the inverse of the real money stock.

On the price side, a contributing factor to the measured rise in velocity may be the upward bias to measured inflation that is implied by traditional Soviet price indices, that is, the so-called Sauerbeck problem.27 This measurement error is estimated to have had a significant impact on the measured rise in velocity in Moldova, for example, prior to the construction of a corrected price index.28

Differences in Velocity Performance

The above section discussed possible explanations for the observed shocks to real balances and velocity. Here, policy responses and the subsequent behavior of velocity are analyzed. While two of the ten countries (Moldova and Ukraine) that experienced sharp increases in velocity in late 1993 to early 1994 have seen velocity decline close to previous levels, in others (especially Armenia, Azerbaijan, Belarus, Georgia, Kazakstan, and Turkmenistan), velocity has remained high. In Lithuania, velocity fell back following a rise that occurred in late 1992—early 1993.

The following points emerge from the discussion: first, regardless of the source of the initial inflation and velocity increases, countries where velocity subsequently fell achieved that result by raising the demand for real balances through establishing high rates of return on monetary assets and other conditions that instilled confidence in the currency. Second, the containment of wage pressures may also have facilitated reductions in velocity, as countries where initial inflationary shocks fed into a cycle of high wage growth were those that experienced more difficulty in controlling inflation and restoring confidence.

Recovery of Real Money Demand

While it has been suggested earlier that nominal exchange rate movements did not appear to play a dominant role in explaining initial surges in inflation and velocity, strong evidence exists that increased confidence in the currency has played a key role in subsequent reductions in velocity and accompanying increases in real balances. As indicated in Chart 3.4, recent periods of increasing real money balances in the Kyrgyz Republic, Moldova, and Russia, as well as the earlier experience of the Baltic states, featured a stable or appreciating real exchange rate, which suggests that reductions in velocity were associated with strengthened demand for domestic currency and a containment of capital flight.

Looking specifically at the experience of Fund-supported programs, it is clear that the four successful anti-inflation programs presented in Table 1.4 featured relatively stable or even appreciating nominal exchange rates together with declining velocity (Table 3.5). In Estonia and Latvia, exchange rates stabilized at the beginning of the 1992 stabilization programs, contributing to a quick decline in the rate of increase in traded goods and overall consumer prices.29 In the Kyrgyz Republic, Lithuania, and Moldova, the sharp reductions in inflation under their second stabilization programs have been accompanied by a halt to the substantial exchange rate depreciations that were registered during the initial programs.

Table 3.5.

Quarterly Changes in Wages, Exchange Rates, and Real Interest Rates Under Fund-Supported Programs1

(Percentage change)

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Sources: Data provided by country authorities; and IMF staff estimates.

Changes in average wages, minimum wages, and the exchange rate (an increase in the latter indicates depreciation) reflect within-period quarterly rates. Except where indicated, the real interest rate is defined as the average central bank refinance rate (simple quarterly basis) less the contemporaneous moving average quarterly rate of inflation.

Defined using commercial three-month lending rate (quarterly basis).

At the same time, in the remaining programs, where inflation was not reduced as envisaged, unanticipated increases in velocity were accompanied by nominal exchange rate depreciation at a rate that was in general significantly higher than assumed under the program.30 This weakening in exchange rates is likely to have contributed to the poor inflation outcomes in these countries by increasing the prices of tradables and adversely affecting inflationary expectations.

Exchange rate and velocity movements, in turn, have been strongly influenced by domestic financial policies—in particular, by the achievement of (or failure to achieve) positive real rates of return to domestic monetary assets. This point is brought out in Chart 3.1; those countries where rates of return were allowed to reach positive levels for a significant period of time (Estonia, the Kyrgyz Republic, Latvia, Lithuania, Moldova, Russia, Ukraine) stopped velocity increases and initiated a subsequent reversal and recovery in money demand. Countries where real rates of return have remained significantly negative (Azerbaijan, Belarus, Georgia, Tajikistan, Turkmenistan)—or have only recently turned positive (Armenia, Kazakstan)—have yet to bring inflation and velocity increases under control.31 Thus, while the achievement of positive real interest rates is not a sufficient condition for reducing inflation, it can substantially strengthen stabilization efforts by stemming capital flight and reducing pressure on the exchange rate, as well as on domestic prices.

The role of financial policies is underscored by the experience of Fund-supported programs. When inflation was brought down successfully, interest rates reached levels that were positive in real terms. In Estonia and Latvia in 1992-93, and in the successor arrangements for the Kyrgyz Republic, Lithuania, and Moldova in 1994, central bank refinance rates became positive in real terms, at least by the third program quarter. In all of these cases, exchange rates stabilized or even appreciated in nominal terms, and domestic inflation declined substantially.

In the remaining cases, when inflation was not reduced as targeted, interest rates remained negative in real terms in all countries except Russia.32 In that country, under the 1993 program supported by a systemic transformation facility inflation remained higher than targeted in the fourth quarter of the year, but monetary policy was tightened significantly, the refinance rate became positive in real terms during that quarter, and inflation fell during the first half of 1994. In Belarus, both Kazakstan programs, and Lithuania’s October 1992 program supported by a stand-by arrangement, real interest rates remained negative throughout the program. While refinance rates were raised significantly in nominal terms, these increases were insufficient relative to the extremely high rates of inflation, contributing to weakness in the currency and rising velocity. Under the first programs in the Kyrgyz Republic and Moldova in 1993, refinance rates were negative in real terms throughout most of the program and inflation objectives were not attained. However, interest rate increases during the program served to set the stage for reduced inflation and a stabilizing of the currency in the period immediately following the end of those programs (i.e., rather quickly under the successor arrangements).

Wage Developments

While it was suggested earlier that exogenous wage movements cannot be considered a primary cause of the increases in inflation and velocity that began in the second half of 1993, there are some indications that high increases in nominal wages in reaction to the initial inflation shock sustained and fueled inflationary pressure in a number of countries, undermining efforts to reduce inflation and increase real money balances.

This possibility is brought out in the experience of Fund-supported programs in the region, where the failures in achieving inflation targets were accompanied by excessive wage increases. All programs sought to achieve wage restraint, and generally envisaged wages in real terms to either remain constant or decline over the program period.33 Only in the successful stabilization efforts, however (the initial programs in Estonia and Latvia, and the successor programs in the Kyrgyz Republic, Lithuania, and Moldova)—as well as in the second Russia program supported by the STF—were actual wage increases roughly in line with targeted rates of inflation and monetary expansion. In the remaining programs, rates of wage growth were significantly higher than the corresponding inflation targets—despite more ambitious monetary efforts in some cases. Moreover, in most countries, average wages rose broadly in line with minimum wages, suggesting that the authorities may have been attempting to maintain real wages in the face of generalized pressures on prices. Those program countries that were most successful in achieving sustained reductions in velocity (Estonia, Latvia, Lithuania, Moldova) did so during periods when wage increases were relatively restrained.

Conclusions and Implications for Stabilization Policy

The findings of this study suggest the following lessons for stabilization policy. Sustained reduction in broad money growth is fundamental to inflation stabilization; the experience of the Baltics, Russia, and other countries of the former Soviet Union confirms the primary role of monetary policy in determining the medium-term rate of inflation. In the short run, however, the relationship between inflation and money growth can be weaker. This was especially so in late 1993-early 1994 when inflation rose sharply in a number of countries, without there having been an acceleration of money growth. First, there are normal lags in the transmission process; second, exogenous factors such as rising import prices or strong wage or administered price increases can have a significant influence on the price level. And third, changes in the underlying demand for money, particularly in conditions of instability and uncertainty, can manifest themselves in exchange rate and price behavior. While determining the exact cause of price movements is difficult, this study has found evidence that all three factors have, at various times, had a strong influence on the behavior of inflation velocity. Moreover, it has proved difficult to subsequently restore domestic real balances.

While a reduction in the rate of monetary expansion is both a necessary and sufficient condition for bringing down inflation, there may be other factors that can assist in speeding the response of prices and minimizing the effects of exogenous shocks. The experience of successful stabilizers suggests that rising demand for domestic money balances has been particularly important. Thus, the achievement of positive real interest rates can stem capital flight and exchange rate depreciation; increasing domestic interest rates or committing to exchange rate stability can also have a signaling effect on expectations that will support monetary tightening. At the same time, avoiding unwarranted nominal wage growth can prevent overadjustment to external price increases or domestic price liberalization.

Finally, the ability in many of these countries to offset declining real money balances with increased creation of informal credit has also weakened the linkages between money and prices, often leading to run-ups of interenterprise arrears in the short run. A large overhang of arrears can give rise to pressures to reverse monetary policy and may have associated real costs as well; thus, policies to prevent an endogenous response of informal credit creation (and in particular those that signal the refusal of the government to “bail out” indebted enterprises) would make stabilization policy more effective.


The analysis in this section draws heavily on numerous staff reports on individual countries in the region over the period covered.


April 1992 is chosen as the starting point in order to abstract from the large decline in real money balances associated with the elimination of monetary overhang at the beginning of that year.


In Russia, inflation after accelerating in late 1994 started to come down around mid-1995.


For rates of growth over discrete time periods, the relationship will not be exact; thus, if Δ represents the percentage change over a given discrete time period, then

ΔP = ΔM + ΔV – ΔY.


In this study, unless otherwise noted, estimates for velocity are derived as an implied index from the path of money, prices, and real output, as in the above equation, instead of using direct estimates for money velocity derived from nominal GDP estimates. This is done primarily to avoid inconsistencies that arise from errors and uncertainties in nominal GDP figures, because (1) estimates of the level of nominal GDP—and thus of the level of velocity—can vary by wide margins and are unlikely to be comparable across countries; (2) the path of the implicit GDP deflator underlying estimates of nominal GDP growth is in some cases markedly different from that of retail and wholesale price indices. Real GDP trends are not shown in Table 3.1.


Changes in velocity have accompanied not only movements in inflation and money growth but also short-term fluctuations in output. Some countries (Armenia, Belarus, Tajikistan, Turkmenistan, Uzbekistan) have registered large seasonal fluctuations in real output, while in others the recorded path of output has been smoother—although it should be noted that estimates of real output movements are tentative and subject to significant measurement errors. In any case, for those countries where recorded output exhibited seasonal behavior, there is little evidence that this seasonality affected the observed paths of broad money or retail prices; instead, there were corresponding seasonal movements in velocity.


Movements in velocity have, by and large, been mirrored by the behavior of real money balances.


While successor or second stand-by arrangements are included in the sample for four countries where the reduction of extremely high inflation remained a program priority, successor stand-by arrangements for Estonia and Latvia are not included because these programs aimed at consolidating progress already made in stabilization, rather than achieving a marked reduction in inflation. Also, to ensure comparability with program definitions, figures for broad money velocity used when reviewing program outcomes and shown in Table 1.4 are defined on the basis of nominal GDP.


Under the 1994 program in Russia supported by a systemic transformation facility, inflation objectives were achieved initially, but end-1994 inflation targets were missed by a substantial margin.


When data have been unavailable and extreme changes in financial and economic structures have occurred, projections of money demand or velocity have been subject to unusually high degrees of uncertainty. Particularly at the outset of the transition period for the Baltic states, Russia, and other countries of the former Soviet Union, empirical work on the demand for money in transition economies was extremely limited and did not exist for the newly independent states. Thus, program projections were based on an analysis of recent trends and contained a significant judgmental element.


The usefulness of standard models is, of course, questionable in transition economies, where nominal variables, such as prices, interest rates and exchange rates, may not clear markets—that is, where “disequilibrium” conditions may apply. Where possible, these factors are accounted for below.


For Russia, simple regressions of monthly inflation against current and lagged values of ruble broad money growth indicate that the bulk of the impact of money growth on prices was felt with a two-to-four month lag. See Vincent Koen and Michael Marrese, “Stabilization and Structural Change in Russia, 1992-94,” IMF Working Paper, WP/95/13 (Washington: International Monetary Fund, January 1995).


To the extent that a lagged price response led to inflation well in excess of contemporaneous rates of monetary expansion, one would normally expect that the resulting rise in velocity would only be temporary, and that, ceteris paribus, real money balances would be restored in subsequent months; indeed, inflation would for some time decline to a level below the rate of growth of money.


By contrast, if real balances declined owing to supply-side factors such as exogenous price pressures—that is, a shift in the supply of real money balances and a movement along the demand curve—the relative rate of return to monetary assets would be expected to fall.


The relative rate of return in Chart 3.1 is defined as >ρd the nominal interest rate on refinance credit less the contemporaneous rate of inflation. It should be noted that focusing on interest rates of the banking system may be improper when a substantial portion of broad money consists of cash holdings (as is so in many of the economies in this study); under such circumstances, pd should be redefined as the negative of the inflation rate. A measure of relative return that included the return on foreign as-sets (pf) would be equally valid. However, analysis of the relationship between real money balances and these alternative measures of the rate of return does not lead to qualitatively different findings from those contained in Chart 3.1.


A number of countries (Azerbaijan, Belarus, Georgia, Moldova) issued new currencies or coupons that initially circulated in parallel (and at a fixed par) with the Russian ruble; in these instances, a “crisis” in confidence in the domestic currency may have occurred later, after July 1993, when Russia demonetized pre-1993 ruble notes and at the same time significantly reduced the provision of new interstate credits—causing the above states to declare their currencies sole legal tender and leading many countries to finally delink the national currency from the ruble.


Periods of strong monetary expansion would fuel both actual inflation and inflationary expectations, leading to decreased confidence and lower money demand.


It also does not appear that money growth in excess of program targets led to declining confidence in the currency in those countries with Fund-supported programs. An examination of Table 1.4 and Chart 1.6 shows that programs where monetary targets were missed still achieved a relative tightening compared with preprogram levels of monetary expansion.


Care must be taken when interpreting movements in recorded exchange rates. In some cases, official exchange rates were fixed administratively at unrealistically low levels, while domestic currency prices of imports were based on black market rates. Thus, for example, observed exchange rate movements in Azerbaijan, Tajikistan, Turkmenistan, and Uzbekistan have had little effect on inflation.


In contrast to money demand shocks, exogenous inflationary pressures would affect the supply of real balances.


For the four countries (Belarus, Kazakstan, Moldova, and Uzbekistan) for which quarterly price data are available, natural gas prices tripled and oil prices rose by 2 1/2 times during the second half of 1993.


Close trading partners such as Belarus and Kazakstan, in particular, may have suffered from large increases in the prices of non-energy imports from Russia, while countries that were more successful in redirecting trade toward western markets (such as the Baltic states and Moldova) would have been less affected.


It should be noted that in many cases the adjustments in ad-ministered prices were associated with the increases in external energy prices.


As opposed to the underlying level of “liquidity velocity”—conceptually measured to include both informal credits and broad money—which would tend to be more stable.


See Section IV for additional details on arrears developments. A more rigorous approach would be to directly construct a series for “alternative liquidity,” containing both standard monetary aggregates and informal credits, and compare movements in this liquidity indicator with observed price changes. The available literature, however, provides no clear guidelines as to what definition of inter-enterprise credits (i.e., the outstanding stock or the current flow; overall receivables or a definition that excludes overdue arrears) would correspond conceptually to standard monetary aggregates.


Available data on domestically held foreign currency generally include foreign exchange deposits but do not include cash holdings; in addition, there is little information as to foreign currency held abroad.


This problem arises when price indices are calculated using weighted averages of individual price changes in a “chained” fashion (rather than computed in reference to a fixed base period); see for example, Francois Lequiller and Kimberly D. Zieschang, “Drift in Producer Price Measurement in FSU Countries,” IMF Working Paper, WP/94/35 (Washington: International Monetary Fund, 1994). In addition to methodological issues in calculation, price indices in these economies are also subject to inadequacies in the area of coverage; in particular, goods traded in the illegal or semilegal sectors—or even, for some countries, the nonstate sector in general—are not included in the indices. It is not clear, however, whether these deficiencies in coverage would necessarily lead to biases that could help explain the observed velocity trends.


See J. Haley and G. Shabsigh, “Monitoring Financial Stabilization in Moldova: The Role of Monetary Policy, Institutional Factors and Statistical Anomalies,” IMF Paper on Policy Analysis and Assessment, PPAA/94/25 (Washington: International Monetary Fund, December 1994).


In addition to the favorable direct impact on prices, the fixed exchange rate regime in Estonia is likely to have had favorable in-direct effects on stabilization. See Section VI for an analysis of the relationship between exchange rate management and stabilization.


Programs generally assumed either a constant real exchange rate (i.e., nominal depreciation equal to the rate of inflation) or an appreciation in real terms (reflecting the expected effects of domestic financial policies).


The analysis incorporated data until the end of 1994. In some countries, for example, Georgia, there was a sharp deceleration in inflation around mid-1995.


It may be noted that while actual performance was mixed, all programs did aim at domestic interest rates reaching positive real levels, through (1) increases in the central bank refinancing rate; (2) the introduction or widening of central bank credit auctions; and, in a few cases, (3) the liberalization of commercial bank loan interest rates.


Proposed measures included (1) direct control of the wage bill in the budgetary sector; (2) limits on increases in the minimum wage; and (3) tax-based incomes policies governing wages in state enterprises, usually taking the form of a maximum admissible average wage that was a certain multiple of the minimum wage. The exception was Russia, where programs contained no explicit objectives or measures with respect to the path of wages.