Subduing High Inflation in Romania. How to Better Monetary and Exchange Rate Mechanisms?

William Davidson Institute Working Paper 402

if unemployment is high, the country might not be able to bear additional austerity in
order to rebalance the current account. Unfortunately, countries in Southeast Europe
already reveal huge unemployment;¹² and the accompanying social and economic
pains will very likely be compounded when resolute steps toward the restructuring of
their productive sector will be taken.

Forecasts of inflation in transition economies exceeding inflation in the EU
often build on the Balassa-Samuelson paradigm (Halpern and Wyplosz, 1997). In this
analytical framework, the small country economy is made up of a tradable and a non-
tradable sector, with labour as the only input. Prices in the EU, the “large country”,
are given. Under the law of one price, the prices of tradable goods in the small
country are equal to prices in the Union, times the predetermined nominal exchange
rate. Let us assume that this exchange rate was set initially such as the current account
is balanced. Wages in the tradable sector can only increase in the small country when
labour productivity increases in this sector. Then, with labour mobility between
sectors, wages and prices in the non-tradable sector also increase, for constant
productivity in that sector. The price level gradually increases with the catch-up in
productivity. Of course, this kind of “adjustment” inflation would not affect the
current account equilibrium. However, if private agents interpret the change in the
equilibrium exchange rate as depending on relative changes in inflation rates in the
consumer price index, they may feel that the currency is overvalued and the
probability of speculative attacks may increase.

Therefore, if a country opts for a fixed exchange rate regime, either a standard
one or a currency board, it may consider the case for capital controls that dissuade
extensive short-term capital flows and increase the opportunity costs of speculative
attacks (Krugman, 2000). While a Tobin tax may not be effective enough in
dissuading short-term speculation (Kenen, 1995), the mechanism proposed by
Eichengreen, Tobin and Wyplosz (1995) -- where foreigners who borrow domestic
currency must constitute a one-year deposit -- could be effective.

¹² Unemployment rates in Southeast Europe are extremely high even by transition economies standards.
Even if the size of the underground sector is considered unemployment rates of between 30-40% (as in
Macedonia, Serbia, Bosnia-Herzegovina, Kosovo, etc) are staggering.

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