Summary of WP/95/45: “Growth, Nontradables, and Price Convergence in the Baltics”
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

This compilation of summaries of Working Papers released during January-June 1995 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201.

Abstract

This compilation of summaries of Working Papers released during January-June 1995 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201.

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.

Working Paper Summaries (WP/95/1 - WP/95/61)
Author: International Monetary Fund