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

William Davidson Institute Working Paper 487

of tradable goods in BGN depend on the changes in the exchange rate and the changes in
the prices of tradable goods in foreign currency³¹.

The demand and supply of them on the domestic market determine the prices of
non-tradable goods. If we assume that the prices of these goods are a function of the
money market (the deviation of the desired real amount of money at the end of period mt^d
from the actual real amount of money at the beginning of period mt-1), then:

(3)     ln PNT_t - lnPNT_t-1 = γ(lnm_t-1 - ln m_t^d ) + u_t

m is equal to M/P, where M is a selected monetary aggregate, P is the general
price level, and γ is the balancing velocity (0< γ <1). After moving to first differences of
the equation (1) and (2) we get:

(4)     ln(Pt / Pt-1 ) = φ ln(PTt / PT_t-ι ) + (1 - φ) ln(PNT_t / PNT_t—, )

(5)     ln(PTt / PTt-ι ) = αо + α, ln(e, / e,-, ) + α2 ln(PT,> /PTtf1 ) + ε,

After substituting (3) and (5) in (4) we come to the following equation, which
describes the dynamics of inflation.

₍₆₎    ln(P_t /P_t-1)=φ[α₀ +α₁ ln(e_t /e_t-1)+α₂ ln(PT_t^f /PT_t-^f₁)+ε_t]+

(1 -φ)γ(lnm_t-1 - ln m_t^d ) + (1 -φ)u_t

From previous surveys of the demand for money in Bulgaria (Nenovsky and
Yotzov, 1997) we know that the most appropriate approximation for real money stocks
demand is as follows:

(7)     lnm_t^d =β₀ +β₁ lny_t -β₂ lnr_t -β₃ ln(e_t /e_t-1)+ξ_t

where m is currency in circulation (in real terms), y is total real expenses of
households (real monetary expenses or real wages of households may be used³²), r is the

³¹ If we assume that the purchasing power parity of tradable goods is valid (i.e. prices of tradable
goods are exogenously set), then the equation (2) would look like this:

(2')     ln PT_t = lne_t + lnPT_t^f ,

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