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

William Davidson Institute Working Paper 487

Annexes

Annex 1 Structural model of inflation under the Currency Board

After certain simplifications, the inflation under a CB can be approximated by
means of the following structural model, which combines both the balancing between the
prices of tradable and non-tradable goods and the balancing of the money market
(demand and supply of money)³⁰. This model presupposes that the balancing of the
demand and supply of tradable goods is achieved through the volumes, while the
balancing of the demand and supply of non-tradable goods is achieved through their
prices, which are a function of money demand and supply.

The general level of prices is a sum of the prices of tradable (primarily industry
and agriculture) and non-tradable goods (primarily services), PT and PNT respectively
with weights φ and (1-φ).

lnP_t =φlnPT_t +(1-φ)lnPNT_t

If we suppose that the prices of tradable goods are a function of the prices of
tradable goods abroad and of the exchange rate, then the following dependence would be
valid

ln PT_t =α₀ +α₁ lne_t + α₂ lnPT_t^f + ε_t ,

where е is the exchange rate of the BGN as a direct quotation, and PTt ^f is the
price level of tradable goods in foreign currency. The equation (2) shows that the prices

³⁰ This model could be considered as a model of the inflation under a fixed exchange rate which
takes account of the different dynamics of prices of tradable and non-tradable goods. The automatic
mechanism of the CB makes the balancing of the money market (between the desired and the actual
amount of money) extremely fast. This is so, because the money supply, according to the CB rule, is
almost entirely endogenous (set externally for the central bank). If we assume that the money market
is always in equilibrium, then the above model would be limited to the traditional interpretations of
inflation known as the BS effect.

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