Effects of Macroeconomic Policies on Output Fluctuations in Bulgaria

Like many other Eastern and Central European countries, during its transition to a market economy in the early 1990s, Bulgaria experienced high inflation rates, exchange rate volatility, high money growth rates, high lending rates, inefficient public enterprises, unfunded pensions, and other economic problems. In recent years, it has made progress and become a candidate for membership in the European Union. It is important to understand the potential impact of monetary policy, fiscal policy, and exchange rate movements on economic activities so that policymakers know the ramifications of changes in economic policy. For example, it is interesting to determine whether government deficit spending to increase aggregate demand would raise output. It is possible that increased government deficit spending would raise interest rates, crowd out private consumption and investment expenditures, and leave the net outcome uncertain. Policymakers would also like to find whether the conventional approach of currency depreciation would raise net exports and output. Currency depreciation may raise import prices, cause domestic inflation rate to rise, and shift aggregate supply leftward. Wyplosz [WB, 2000], Kalcheva [EEE, 2003], Berlemann and Nenovsky [CES, 2004], and Chobanov and Sorsa [IMF, 2004] studied some of these economic subjects for Bulgaria. Suppose that aggregate spending is a function of real output, the real interest rate, government spending, government tax revenues, and the real exchange rate, that demand for real M2 is determined by the nominal interest rate, real output, the exchange rate, and the expected inflation rate, and that aggregate supply is influenced by the expected inflation rate, the output gap, and the exchange rate. Applying an extended ISLM-AS model, we can express the equilibrium output for Bulgaria as Y 1⁄4 Y M;G;T; 1⁄2 e P P f ; ;Y*; ; , where these symbols stand for equilibrium GDP, real M2, real government spending, real government revenues, the nominal effective exchange rate, the domestic price level, the foreign price level, the expected inflation rate, potential output, the coefficient for the output gap, and the coefficient for the nominal exchange rate. Real output is expected to have a positive relationship with real M2 and real government spending and a negative relationship with real government tax revenues and the expected inflation rate. The sign of currency depreciation is ambiguous, as it would shift aggregate demand rightward due to greater expected net exports and aggregate supply leftward due to anticipated higher inflation via high import prices. The sample ranges from 1994.Q1 to 2004.Q4 with a total of 44 observations. To reduce collinearity, deficit spending defined as D = (G j T) is employed. Quarterly dummy variablesYQ1, Q2, and Q3Yare considered to measure potential seasonal effects. All the data were collected from the International Financial Statistics published by the IMF. Y, M, and D are measured in millions. An increase in the real effective exchange rate, e = e(P/P ), means an appreciation, and vice versa. The lagged CPI inflation is Atlantic Economic Journal (2006)34:239Y240 * IAES 2006 DOI: 10.1007/s11293-006-9012-3