In 1991, the rate of inflation in the Czech Republic, Hungary and Poland was 57%, 35% and 70%. At the end of 2001, it was everywhere below 8%. We set up a small structural macro model of these three economies to account for the process of disinflation. We show that a simple macro model, with forward-looking inflation and exchange rate expectations, can adequately characterize the relationship between the output gap, inflation, the real interest rate and the exchange rate during this period. This model allows us to assess the relative importance of the interest rate and exchange rate channels in determining the path of disinflation.
During the last decade, several economies in transition have achieved both inflation and output stabilization, by pursuing different monetary policy strategies. In this paper, we study the process of disinflation in the Czech Republic, Hungary and Poland (CHP). In the course of one decade, these countries have stabilized inflation and the exchange rate and have resumed output growth, while at the same time maintaining fiscal discipline (see Table 1).1 In this paper, we interpret and model the process of monetary stabilization; in particular, we want to focus on the role of interest and exchange rates in the transmission of monetary policy impulses.Modeling the history of disinflation in these countries may seem an adventurous task. Reading the official policy reports of some central banks during the past decade, one often encountered statements implying that: (i) monetary aggregates behaved unpredictably, (ii) the relation between money and growth was unpredictable; (iii) price indexes were unreliable and essentially responded to domestic cost pressures, …, (iv) in addition to being heavily distorted by changes in administrative prices; (v) changes in interest rates did not significantly affect in a negative way domestic demand, …, (vi) but might instead induce undesirable appreciations of the exchange rate, …, (vii) thus fuelling into inflation either through the induced currency inflows or through wealth effects and aggregate demand pressures. What might monetary policy have done in such circumstances? To rely on monetary stabilization policies would have seemed a hopeless task. However, in this paper we take a rather different approach. Things were not as bleak as the above statements imply. On the contrary, even through the years of transition, monetary policy has been a relatively powerful and reliable tool for controlling aggregate demand and price pressures. To support this argument, we build an “orthodox” model of monetary policy, focusing in particular on the role of interest and exchange rates in the transmission mechanism.2 In this model, by appropriately selecting a moderately restrictive path for the nominal and hence for the real interest rate, monetary authorities are able to target the path of the nominal exchange rate and to induce a controlled appreciation of the real exchange rate. In the end, this process gradually steers the economy towards single-digit inflation, while also helping to contain the output costs of stabilization. We will show that such a model adequately characterizes the path of macro variables in CHP from 1991 to 2001, and that the estimated equations are well behaved and reasonably stable across time.3
The paper is organized as follows. In Section 2 we describe the process of macroeconomic stabilization and the evolution of monetary policy in the three countries. In Section 3 we discuss the specification of our model in the light of alternative modeling strategies. In Section 4 we present and evaluate the estimated models. Section 5 concludes.
In this paper we have shown that a simple open macroeconomic model with forward-looking inflation and exchange rate expectations can adequately characterize the relationships between the output gap, inflation, the real interest rate and the exchange rate during the course of transition. These findings go against a widespread skepticism, which permeated a large part of previous research on these issues. The results of the estimation and testing of three models for the Czech Republic, Hungary and Poland, are consistent with our view of the transmission mechanism and with the main hypothesis, that a central role of domestic interest rates in originating policy impulses is compatible with different strategies concerning exchange rate policy. The different experiences of the Czech Republic on one hand and of Hungary and Poland on the other are examples of these strategies. In particular, we have characterized empirically the policy rules prevailing in each country, and assessed the relative importance of the interest rate channel on aggregate demand and of the exchange rate channel, which affects both aggregate demand and supply, in determining the path of disinflation. From this perspective, it is interesting to observe that the effect of the real exchange rate on the evolution of inflation is much more direct in the case of the Czech Republic relative to the other two countries. This corresponds well to the fact that the CNB consistently placed a greater emphasis, relative to the other two central banks, on the role of real exchange appreciations as a means to disinflation. For the Czech Republic we also found that real interest rates affect demand only with a very long lag, whereas the competitiveness effect takes place with a shorter lag and is much stronger than in the other countries; again, this corresponds well to the different exchange rate strategy pursued by the CNB. Despite these differences, we also found that the effects of changes in the real interest rate and in the real exchange rate on aggregate demand are in each case well identified and significant.
Our results show that models, which are broadly similar from the qualitative point of view, may be successfully made to fit different policy strategies adopted in economies in transition. This provides an important crosscheck on the validity of our modeling framework, and suggests that “orthodox” relations between macroeconomic variables were established rather soon after the beginning of transition.35 In addition, the fact that some diagnostic tests give evidence of instability, but only limited to the first few years after the start of transition, confirms this view.
This econometric evidence has a more general implication for the current debate on monetary policy in transition. Following the discussion in Section 2, our findings provide strong support for the feasibility of an inflation targeting (IT) strategy in transition economies. This strategy may be adopted, in our view, as soon as the process of disinflation has been completed. In this perspective, IT emerges as the natural follower to a strategy of crawling band (as in Hungary and Poland), as well as to a strategy of exchange rate peg (as in the Czech Republic).
