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

William Davidson Institute Working Paper 487

fundamental variables (Jones, 1998)². Moreover, many research papers on the topic
suggest that the nominal and particularly the real catching-up process of Eastern
European countries will take a lot of time (Fischer and al., 1998, Kolodko, 2000). In this
framework, we think that it would be more appropriate to speak of some reasonable
levels of convergence between the two groups and not in the context of absolute and
unconditional convergence?³

(iii) What are the sources of inflation under the CB arrangements? Which factor
dominates - monetary, real or the imported inflation? How the CB influences the relative
prices’ structure i.e. the microfundamentals of inflation? What is the role of labor
productivity (particularly of the tradable and non-tradable sectors) in the real exchange
rate movement?

(iv) What should be the optimal price growth rate in Bulgaria? Suppose we
reached the agreement that the prices in the country should rise higher than those of the
euro area by x % (given that the BS effect exists and its estimation is valid⁴). And the
question of the optimal level of euro area prices arises (in some assessments it is higher
than the observed and targeted level by the European Central Bank (ECB), Wyplosz,
2000). If the euro area rate is 4-5%, the optimal inflation rate in Bulgaria would be [4-5 +
х] % i.e. it is significantly higher than the level we experienced in the recent years in the
country. In the light of the above argument, how could the inflation dynamics under the
CB in Bulgaria be interpreted when there were years of low inflation (1% in 1998), as
well as months of deflation (see. figure 1)?

(v) Does the catching-up process favor the theory of endogenous currency area
where real economy integration starts with a common currency? To some extent, the CB

² It is known that the price levels in the EU (Ireland is an indicative example - see. Artus, 2001),
and in the different states of USA are significantly divergent (Kim, 1997).

³ The impossibility and even the dangerous side of inflation convergence prior to the monetary
integration were stressed previously by De Grauwe (1992, 1995), Bayoumi and Masson (1995). See
also Kocenda and Papell (1997) and Kocenda, (2001).

⁴ It is very difficult to measure accurately and predict ex ante BS effects (Brada and Kutan, 2001)

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