Economic Models - Convex Optimization

Inflation Control in Central and Eastern European Countries 175
because of a natural price rigidity with respect to negative corrections, the
re-alignment of relative prices took the form of a sudden increase and a steep
inflation followed: by opening to the international trade (and by introducing
the proper legislation, in order to force the local producers to face a harder
budget constraint), the countries in transition had a chance to import a price
structure similar to the one of their commercial partners. In fact, being the
exchange rate fixed, the domestic producers could not raise their prices too
much without losing competitiveness with respect to the foreign ones.
Slovenia followed a different approach to disinflation, targeting the
growth of a relatively narrow monetary aggregate (M1); according to Capriolo
and Lavrac (2003), anyway the key characteristic of the period was the
continuous intervention on the foreign exchange market in order to prevent
an excessive real rate appreciation (contrary to the strategy of the Bundesbank
and of the Eurosystem, the control of M1 was also enforced with nonmarket
instruments and procedures). Since mainstream optimal currency
area literature prescribes a greater incentive to adopt a stable exchange rate
to the countries more open to the international trade, the fact that the outcome
is actually reversed means that price stabilization rather than trade
was the priority in the exchange rate commitment served in Poland and in
Czechoslovakia.
Fixing the exchange rate may have contributed to price stabilization,
and inflation actually dropped very quickly, but there are certain differences
remained with respect to the EU, leading to a strong real exchange rate
appreciation. This may have been partially due to the Balassa-Samuelson
effect: assuming that the marginal productivity and the wage in the sector
of internationally traded goods, is set on the foreign market and that the
same wage is transferred to the production of the non-traded goods, then
the productivity gap between the two sectors is compensated by a price
increase in the less productive domestic sector. This yields a progressive
appreciation of the real exchange rate and higher domestic inflation.
The faster growth of productivity, determined by the transfer of
technology from the international trade partners and the more efficient allocation
of the resources within the economies, compensated part of the pressure
on the domestic producers, but the fixed exchange rate arrangements
were not sustainable for a long time: Poland switched to a regime of preannounced
crawling peg as early as 1991, later coupling it with an oscillation
band which was gradually widened until it was finally abandoned in 2000;
Czech Republic resorted to a free float without explicit commitment as
early as 1997 under the pressure of a speculative attack, its currency having
progressively over-evaluated in real terms over time. Both the countries