Dual Inflation Under the Currency Board: The Challenges of Bulgarian EU Accession

William Davidson Institute Working Paper 487

Second, the BS effect is mitigated by arbitrary liberalized price of main services
during the transition period. In this respects market forces do not determine the principal
part of the service price behavior. In this case, BS effect has a weaker influence on
relative price adjustments.

Third, we should point out that we use labor productivity in stead of total factor
productivity, which determines the prices of different goods and services, and thus we
inevitably put some limits on the estimation of the BS effect. During the transition
industrial structures were privatized. The tradable sector demands essential, productivity
increasing investments. Further, industries gradually adjust to new technologies and new
quality and standards of production and thus resulting in additional price increase of
tradable goods. In this case dual inflation is weaker.

In the fourth place, labor markets in ex-planned economy is quite rigid (see annex
3), industrial workers are considerably high qualified and it is hardly likely for low
qualified employees from the services sector to get the higher real salaries of all in the
tradable sector. The real wages in the industry sector are much more rigid than the wages
in the non-tradable sector and we could expect that wages might not converge across the
sectors or get equal with the time. Moreover, if wages are not market determined,
productivity formation of the wages in the tradable sector does not hold. This puts some
constraints on the existence of the BS effect.

Fifth, according to "the cost recovery hypothesis" (Aglietta and al., 1998, Ross,
2000) in the post-stabilisation period the prices of liberalised services are striving to
incorporate capital expenses, which have been inherited free of charge from the state.

Sixth, there are also some microeconomic factors and government policies that
cause deviations from the ‘law of one price’ (LOOP), which should hold in the case of
tradable goods. There are differences in the local (national) expenditures on non-tradable
goods and services (transport expenses, on local level, availability of offices, storing
facilities, etc.), differences in the customs tariffs and taxes, (which reflect in various
prices of identical goods in different countries), and the mark-up differences among

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