William Davidson Institute Working Paper 402
During the 1999 crisis, the NBR, instead of raising interest rates, bough lei
massively (and sold reserves, as shown in Figure 7). This may have limited the size of
the devaluation, but at the cost of a rising default risk on foreign debt due to reserve
depletion.
9. More empirical evidence on the devaluation - inflation relationship
Let us consider more in depth the factors that contributed to the steady
nominal devaluation of the leu. In Figure 9, it can be seen that the nominal exchange
rate has evolved in pair with prices in the goods market.
---CPI -----Exchange Rate Index
Figure 9. Nominal exchange rate and CPI Indexes (base 100 in December 1991).
January 1992 to March 2001. Source: NBR
But has the leu depreciation been a major cause of price inflation or, as
elementary monetarist logic would imply, the nominal devaluation only reflects, with
a lag, the price increase? A Granger causality test tends to corroborate the former
hypothesis, indicating that exchange rate hikes lead the rise in prices. But the
monetarist logic is not completely falsified. A similar test run this time on inflation
and money growth rate shows that the money growth rate also leads the price increase
(see Appendix A for the two tests).
Of course, a theory of inflation for economies with a distorted microeconomic
structure and lack of basic institutions like the Southeast European ones is difficult to
work out. Therefore we limit ourselves to a basic empirical approach and develop a
simple VAR model, considering the interplay between changes in prices, changes in
the money stock and changes in the nominal exchange rate. Data are monthly, in the
interval 01:1997 to 03:2001. We did not consider earlier data, as the exchange rate
was not fully liberalized. Equations of the model are presented in the Appendix.
The response of the inflation rate to a shock in the money growth rate (DRM)
and in the devaluation rate (DVN) is depicted in the figure below. As can be seen, a
one standard deviation impulse in the former variables entails significant inflation
acceleration (up to 1.5% per month inflation increase). The maximum impact is
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