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
mtd
from the actual real amount of money at the beginning of period mt-1), then:

(3)     ln PNTt - lnPNTt-1 = γ(lnmt-1 - ln mtd ) + ut

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 / PTt-ι ) + (1 - φ) ln(PNTt / PNTt, )

(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(Pt /Pt-1)=φ[α0 +α1 ln(et /et-1)+α2 ln(PTtf /PTt-f1)+εt]+

(1 -φ)γ(lnmt-1 - ln mtd ) + (1 -φ)ut

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)     lnmtd =β0 +β1 lnyt -β2 lnrt -β3 ln(et /et-1)+ξt

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 PTt = lnet + lnPTtf ,

35



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