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Stabilization after the initial shocks

Stabilization after the initial shocks
In central and eastern Europe, the transition started with price liberalization and trade liberalization for consumer goods. At the same time the state sector was not performing and output and input allocation problems emerged. Not with standing some very high tech based industries, the vast majority of state companies were totally unprepared for participation in the market economy. The result was a highly uncertain situation in which prices stopped to have a regulatory function and the national currency lost its value and its role for accounting purposes.
How to minimize the expected destabilization caused by the initial shocks of economic liberalization? It is important to realize that once prices will be liberalized severe inflation may emerge. The policy package comprised five measures: (i) price liberalization; (ii) restrictions on the wage rate inflation indexation, this to stop the wage-price inflation spiral; (iii) balancing the budget (fiscal policy) by increasing taxes and cutting expenditure programmers; (iv) a restrictive monetary policy which aimed for a real interest rate on Zloty saving accounts; and (v) the introduction of a domestically convertible Zloty exchange rate regime which facilitated foreign trade. In the period after the initial adjustment, monetary policy needs to be geared at low inflation and needs to make sure that the real interest rate (the nominal interest rate corrected for inflation) is at least higher than zero.
The short run effect is inflation and adjustment of relative prices, the medium term effect should be the adaptation of production to the new circumstances. The exchange rate of a transition country is ultimately related to the relative competitive position of the country’s economy vis-à-vis their trading partners. In the short run, the exchange rate hence influences the relative position of domestic producers vis-à-vis foreign producers and the position on the current account. The first lesson that can be drawn from this experience is that it is sensible to devaluate the domestic currency at the eve of a liberalization/stabilization program; this incorporates part of the anticipated inflation beforehand. The second lesson is that fixed nominal exchange rates are not good policy. A better approach is to focus on exchange rate stability measured in real terms. This can take the form of a crawling peg regime with the central bank temporarily intervening at the upper and lower limits of such a peg.

Maret 13, 2009 - Posted by | TUGAS KULIAH TEORI EKONOMI

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