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

William Davidson Institute Working Paper 487

nominal interest rate, and ln(et/et-1) is the depreciation of the BGN (the Euro) against the
US Dollar³³.

The econometric form of the function of measuring inflation (in equation (6)) is:

(8)     ln(P_t /P_t-1 ) = c0 + c 1 ln(e_t /e_t-1 )+c2 ln(PT_t^f /PT_t-₁ )+c3 (lnm_t-1 -lnmd )+&_t

where (lnm_t-1 -lnm_t^d )is the difference between the money supply at the time t-1
and the assessed values of the money demand at the time t in equation (7). According to
the theoretical treatment the expected signs of the coefficients in equation (8) are the
following:

ci + с2 > 1

<

с3 > 0

The interpretation of the sum of the two coefficients (c1 + с2) is based on the
assumption that the LOOP for tradable goods is in force. In the case where c1 + с2 =1,
we have a complete exchange rate pass-through effect, and the change in the prices of
tradable goods expressed in foreign currency and the effect of the exchange rate change
are fully transposed in the prices of tradable goods expressed in the local currency.

In the case where c1 + с2 <1 we have an incomplete exchange rate pass-through
effect, and where c1 + с2 >1 we have excess response of tradable goods prices. The

³² In this case wages participate in the equation on the side of the demand for money as an
approximation of the transaction demand. Actually, wages form prices through costs as well. Prices
in this case are positively linked with wages and negatively linked with productivity. The different
dynamics of productivity and wages in the tradable and non-tradable sectors are the foundation of the
Balassa model.

³³ In the money demand function, instead of the depreciation of the BGN against the USD we may
use inflation. The final form of the function of the inflation is:

(8')

ln(Pt/P-1) = Φα -(1-φγβ0 + [φα + (1-φγβMet/e_tJ+φα2ln(PT^f /PT-i) +

+(1-φ)γlnm_t-1-(1-φ)γβ₁lny_t+(1-φ)γβ₂lnr_t+φε_t-(1-φ)γξ_t+(1-φ)u_t

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