metadata: authors: 0: author: Solimano, Andres
1: author: Yuravlivker, David E.
2: author: DEC
count: Hungary
docna: 0: docna: Price formation, nominal anchors, and
            stabilization policies in Hungary : an empirical analysis
docty: Policy Research Working Paper
subtopic: Economic Conditions and Volatility,Currencies and Exchange Rates,International Trade and Trade Rules,Inflation,Macroeconomic Management
teratopic: Environment
abstracts: cdata!: The authors empirically explore the
            inflationary process in Hungary. Using monthly data, they
            provide econometric estimates of the determinants of
            inflation for 1990-92. Empirical estimates of price
            equations - both consumer price index (CPI) and producer
            price index (PPI) - show the exchange rate's
            quantitative importance and statistical significance in
            price formation in Hungary during the period of intensified
            reform as the economy became more open to international
            trade in both inputs and final goods. Their estimates show
            that the money supply affects consumer and producer prices
            with several lags; its impact on prices is small in the
            short run. Nominal wages have a more significant effect on
            the CPI than on the PPI. The authors present policy
            simulations of alternative rules for the exchange rate and
            the money supply and their effect on the rate of inflation
            and the level of the real exchange rate. They find that a
            rule of fixing the exchange rate entails a lower level of
            CPI inflation - 5 percentage points less of CPI inflation a
            year - than if the rule is based only on reducing the rate
            of money growth (to 1 percent a month). But a fixed exchange
            rate policy is associated with greater appreciation of the
            real exchange rate than is the policy of money-based
            disinflation - nearly 4 percentage points more real
            appreciation a year. A PPI-based exchange rate rule
            stabilizes the real exchange rate at the cost of a
            substantial acceleration in inflation. These exercises
            illustate the nature and magnitude of the tradeoffs between
            faster disinflation and the level of external
            competitiveness in an open economy such as Hungary that uses
            the exchange rate as a nominal anchor in disinflation.
geo_reg_key: 517208,517190,517191
repnme: repnme: Price formation, nominal anchors, and
            stabilization policies in Hungary : an empirical analysis
display_title: Price formation, nominal anchors,
            and stabilization policies in Hungary : an empirical analysis
listing_relative_url: /research/1993/12/698717/price-formation-nominal-anchors-stabilization-policies-hungary-empirical-analysis
topicv3: Macroeconomic Vulnerability and Debt
            m1326057 1104,Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Exchange Rate Policy m1327143 1124
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment
origu: UNKNOWN
no_of_pages: 42
model_extractions: POLICY RESEARCH WORKING PAPER 1234

# **Summary findings**

Solimano and Yuravlivker emp.-ically explore the inflationary process in Hungary. U;ing monthly data, they provide econometric estimates of the etetrininaints of inflation for 1990-92.

Empirical estimates of price equations - both consumer price index (CPI) and producer price index (PPI) - show the exchange rate's quantitative impor:ance and statistical significance in price formation in Hungary during the period of intensified reform as the economy became more open to international trade in both inputs and final goods.

Their estimates show that the money supply affects consumer **and** producer prices with several lags; its impact on prices is small in the short run. Nominal wages have a more significant effect on the CPI than en the PPI.

Solimano and Yuravlivker present policy simulations of alternative rules for the exchange rate and the money suipply andl their effect on the rate of inflation and rthe level of the real exchange **ratc.** They findl that a role ot fixing the excoange **rate** centails **a** lower level of (:II inflation -- .5 percentage points Itss of ( Tl inflation a year - than if the rule is based only oti reluCitleng tie ralte of moncey growth (to I percent a monith). Bliut a fixed exchange rate policy is associated witli greater appreciationi of the real exchange rate tlhatn is the - policy of money-based disinflation nearly 4 percen.age points more real appreciation a year. A PlPllbased exchange rate rule stabilizes the real exclhange rate at the cost ot a substan-tial acceleration in inflationi.

These exercises ililistrate the nature and magnittide ot the tradeoffs between faster disinflation and the level of **eyrPrnil** roirpnt¶ttiiveness in an opern economy such as Hunigary that uses the exchange raIte as a nxominl.l anchor in disinflationi.

This paper-a joint product of the M.ocroeconomics and Growth Division, Policy Reseairch Department. and E:urope and - Central Asia, Country Department **11,** Country Operations D)ivision is part of a larger effort in the Bank to study the macroeconomics of transition. Copies of the paper are available free from the World Banlk, 1 18 H Street NW, Washington DC 20433. Please contact Susana Florez, room NI 1-018, extension 39075 (36 pages). Decemher 1993.

_7The Policy Research Working Paper Series disseminates the findings of work in progress to incoura?r the cxch.hni.'c of iduas_ **_aboul_** _development issues. An objective of the series is t get the findings out qu:;klv, eien if tJe rresentationts ,re,kss than tltirih ishesd. iesi. paters carry the names of the authors and should be used and cited ac ordingIv The findings,_ **_iit_** _s'pr'tat, ion a_ i, _lusons are_ J _k authors_ **_oun_** _and should not be attributed to the World Bank, its E:xecutive Board of Directos. or anv of its miernher cos_ **_wirres_** _I_ Produced by the Policy Research Dissemination Center
<!-- Start of picture text --> Price Formation. Nominal Anchors. and Stabilization<br>Edicies in Hunatuy.<br>An Empirical Analysis.*<br><!-- End of picture text --> <!-- Start of picture text --> By<br>Andris Solimano<br>,PRDTM)<br>and<br>David E. Yuravlivi..r<br>(EC2CO)<br><!-- End of picture text -->

* Helpful comments by Alan Gelb, Michel Noel, Mark<sup>Stone, Artur Szentgyorgyvari and</sup> and Imre Tarafas to a first draft of this paper<sup>are appreciated.</sup>

* We acknowledge the efficient assistance from<sup>Bruce Courtney and Raimundo Soto in the</sup> preparation of this paper.
# TABLE OF CONTENTS.

|1. INTRODUCTION<br>........................<br>.<br>.|.<br>1|
|---|---|
|2. BACxGROUND. MAN MACROECONOMIC<br>DEVELOPMENTS<br>IN HuNGARY|.<br>3|
|3. A SMPLE MODEL OF INFLATION<br>..|11|
|4. ECONOMETRC ESTiMATEs.................................|.........<br>16|
|5. PoLICY OpONS FOR DISIFATION. A SIMULATION<br>ANALYsIS .<br>.22||
|6.CONCLUDING<br>REMARS..|31|
|REFERENCES ....<br>.................|33|
|FIOuI.E.1..|7|
|FIGuRE2 ....|16|
|FiGuRE 3 .....|29|
|FiouRE4.............................................|30|
|APPENDIX...............................................|.........<br>35|

# TABLES

TABLE I .............................................. .... _5_ TABLE 2 ...... . ................. 20 _TlABI._ 3 .............................................. 21 TABL.DE 4 ....................... 27 TABLE 5 ............................................. 28 i
## 1. IntroducQon,

Economic stability is a key pre requisite for further progress in structural transformation in transition economies. Low and predictable inflation is important to assure that market signals do convey relevant economie informaticn on relative scarcities in the economy so to properly guide resource allocation decisions. Moreover, recent research is showing a high sensitivity of investment to different measures of economic instability, chiefly the rate of inflation'. **Then** not only static resource allocation but also capital formation and growth can be adversely affected by inflation. In this perspective, a better understanding of the nature of the inflationary process and the policy choices to reduce and stabilize inflation is an area of great policy relevance. Further, in economies increasingly integrated to world markets in trade of both final goods and intermediate inputs, the use of the nominal exchange rate for anti-stabilization purposes has also an impact on izlternr. -? competitiveness that needs to be carefully considered.

In the group of countries undertaking post-socialist transitions, Hungary stands out as one with a relatively long traditicn in economic reform, which adopted a gradual approach, and where large macroeconomic imbalances and rampant inflation have been avoided.<sup>2</sup> II. contrast to other countries in Cie region, in Hungary the acceleration of the reform process after the political change of the late 1980s has been accompanied by moderate inflation: in the last four years, the CPI increased by an annual average of 25 percent. On the

# ' See Pindyck and Solimano (1993).

2 Of course, historically that was not always the case. Hungary had hyperinflation both in 1923 and in 1946. The latter one was one of the most virulent in recent economic history (See Solimano, 1991).
stabilizztion front, the problem of Hungary is how to converge to lower inflation levels (1015 percent per year? below 10 percent? ) without hampering other objectives of economic policy, like the resumption of growth, and the maintenance of external competitiveness.

This paper investigates the process of price formation in Hungary and evaluates the use of different nominal anchors for disinflation. It provides orders of magnitude of the trade-offs between inflation and the real exchange rate during the course of stabilization under alternative monetary and exchange rate policy rules. The paper is organized as follows: section 2 provides a background on recent economic developments in Hungary. Section 3 sets-up a simple model of inflation determination in which both aggregate demand and aggregate supply factors interact to determine the rate of inflation. In section 4, the model is estimated econoinetrically using 1990-1992 monthly data of consumer -ices (CPI), producer prices (PPI), wages, the exchange rate, international prices and money. This sample covers the most critical trandition period. In section _5,_ the econumetric estimates are used to simulate the following policy alternatives: (1) a policy of fixing the exchange rate; (2) a policy of reducing the rate of growth of the money supply; (3) a combined policy of frixing the exchange rate with reducing the rate of money growth; (4) a PPP (Purchasing Power Parity) based exchange rate policy. These policies are evaluated in terms of two criteria: (a) impact on inflation and (b) effects on the reai exchange rate. Finally, section 6 includes some concluding remarks.

2
# 2. Backgrgund, Main Macroeconomi Developments in Hungary.

Hungary was the first COMECON country to start moving away from rigid central planning as early as the 1960s. The reform process started with the adoption of the New Economic Policy in 1968 and was n^ver fully reversed, as happened for instance, in post1968 Czechoslovakda. Despite periods of some back-tracking, particularly in the mid-1970s, 'reform communism' allowed Hungary much more time to develop practices and attitudes conducive to the functioning of markets than other countries in Eastern Europe and the former Soviet Union. Vhile the journey toward private ownership, hard budget constraints, and free markets and prices started in earnest only in the mid-1980s, two decad^s of experimentation with market socialism did prepare the ground.

In the second half of the 1980s, expanding domestic demand and exports surpluses in non-,convertible trade werm accompanied by declining convertible ex ,rts. Relaxation of restrictions on foreign exchange purchases for travel purposes led to substantial capital outflows. These factors, together with increasing interest payments, resulted in a sharp deterioiation of the current account in convertible currencies and to a severe foreign exchange liquidity crisis.

The democratic Government elected in May 1990 responded forcefully to the crisis by implementing a stabilization and structural adjustment program that was supported by the IMF and the World Bank. A key element of the program were periodic adjustments of the exchange rate to enharce the international competitiveness of Hungarian exports while preventing an inflationary spiral. The Government's strategy aimed at complementing macroeconomic stabilization with a program of systemic transformaticn to a full-fledged 3
mArket economy through liberalizing extemal trade and decontrolling prices, privatizing state-owned enterprises, encouraging the development of the private sector, and establishing a liberd4 C rvironment for foreign investment.

The stabilization program oi 1990-91 was very successful in tuming around the **current account** of the balance of payments from a deficit of nearly $1.5 billion in 1989 to a **surplus of $123** million in 1990 and about $300 million per year in 1991-92 (Table 1). This **adjustment was achieved** despite unfavorable external shocks, including probably the worst **drought this century,** the unexpected shortfall in Soviet oil deliveries, higher energy prices resulting from the Gulf crisis and the collapse of CMEA trade. As the CMEA collapsed, **exports** were successfully edirected to western markets and the country keDpt currrnt on all its external debt obligations. The situation stabilized, Hungary's access to international bond markets greatly improved and the country attacted over one-half c f the total direct foreign investment provided to Central and Eastern Europe in 1991-92. After a slow start, foreign capital inflows accelerated rapidly in 1991, spurred by a rapid growth of direct foreign investment that amounted to nearly US$1.5 billion in each of the last two years. As a result, intenational reserves surpassed US$5 billion by the end of 1992, equivalent to about six months of imports.

4
|HUNGARY:|TAB<br>SELECTED|LE**1**<br>)ECONOMI|C INDICATO|RS||
|---|---|---|---|---|---|
||i989|1990|1991|1992<br>Prel.|1993<br>Proj.|
|_r;_<br>''<br>n7rowth<br>(an_val_change. %)|0.4|-3.3|-10.2|-4.5|-2.0|
|o/w**indutiai**prduction|-2.0|-7.7|.16.7|-10.0|**2.0**|
|hxpotuONFS (volume indices)|1.2|-2.7|-8.7|**4.7**|-10.0|
|**Imporu**GNFS (volume indices)|1.8|-4.6|-7.7|-4.1|**2.0**|
|Cu..t<br>Account<br>(million dolls)|.1438|**123**|**267**|314|-1;00 -|
|**_(%_**of GDP)|-4.9|fl.4|**0.b**|0.9|4.5|
|Direec Forcign Investmnent<br>**(million**dollan)|187|**311**|1459|1415|1300|
|Consolida<br>statebudget||||||
|**(%**of CDP)|-1.3|-0.1|_-4.5_|-7.6|-7.0|
|CPI<br>**(annual**<br>**Mte**of change,**%)**|17.0|28.9|_35.0_|23.0|2-24|
|PPI (avenge)<br>**(annual**mte of change, %)|**15.4**|22.0|32.6|11.5|10-12|
|NomiMua<br>devaluation<br>(ate of**c'ange, %)**|22.0|**5.0**|22.0|_5.5_||

The impact of external shocks and domestic reform on aggregate economic activity has been severe: measured GDP has contractec. 'y a cumulative 18 percent between 1989 and 1992, reflecting the collapse of CMEA trade, the restrictive impact of stabilization po!icies on domestic demand and the falling output in the SOE (State-Owned Enterprise)<sup>sector.</sup> Production in both industry and agriculture declined by 30-35%, while the rate of consumer price inflation accelerated and peaked at _35%_ in 1991, declining thereafter to 23% in 1992.' 3 See Solimano (1993a) and (1993b) for a comparative analysis of output behavior during the post-socialist transitions.

_5_
As a result of the recession, unemployment increased rapidly to over 12 perceia of the labor force by end-1992.

The continuous recession led to a rapidly deteriorating fiscal situation. On the revenue side, tax receipts fell short of expectation! as the drop Ln output was larger than expected, the SOE tax base continued to shrink, and the Gover- rent was unable to collect efficiently from the -,xpanding private sector. On the expenditure side, the rapid hicrease in the number of both unemployment claims and social assistance requests exerted powerful upward pressures, which have been difficult to resist in the absence of a sharp curtailment in the acquired rights of sorme social security recipients. Thus, the consolidated state budgct deficit increased to 4.5% of GDP in 1991 - more than twice the projected level- and again to 7% of GDP in 1992. This levels of the fiscal deficits are certainly incompatible with a low inflaton rate in the long run. 'However, in the short to medium 6
**FIGURE** 1

# HUNGARY: NOMINAL EXCHANGE RATE AND PRICE INDICES

<!-- Start of picture text --> (Jan 1991 a 100)<br>160<br>1sO<br>140- r<br>120-<br>110<br>1-0 Nominal<br>X00 Ex,-hange Rate<br>90'<br>199i1.0 1991.04 1991.07 1991.10 1992.01 1992.04 1992.07 1992.10<br><!-- End of picture text --> 7
term the government has resorted to noninflationary means of financing. In fact, the Government was able to finance these large deficits mostly by borr3wing from domestic commercial banics, which captured the rapidly growing household savings. Thus, the fiscal deficits were financed without increasing foreign indebtedness or exacerbating inflationary pressures.

Preliminary data for the first half of 1993 indicates that economic activity has continued on its **downward** treid. Industrial production and sales were roughly stagnant compared **.o** the same period last year, although several branches 'e.g., basic metals, machinery and equipment) show growth rates of 10-15%. rie agricultural sector, however, is in a state of flux following the severe _c_ ought and the ongoing changes in ownership structure. Consumer price increases reflect the two-step hike in the minimum VAT rate from 0 to 10%, and expectations for a decline in the 1993 rate of inflation may not materialize.

The objective of reducing inflation led to a slowdown in the rate of devaluation in late 1992 and early 1993, which, along with sizeable capital inflows, produced an appreciation of the real exchange rate. Partly as a result of this appreciation and partly because of lagged adjustment to the collapse of CMEA trade and the recession in Western countries, exports declined sharply in the first half of 1993. ii.erchandise exports fell by about 30%, and the resulting trade deficit was over $2 billion, compared to $275 million in the corresponding period last year. The NBH has reacted to these developments by accelerting the rate of mini-devaLuations since the second quarter of 1993 with potential inflationary consequences operating directly through the cost of imported goods and inputs and indirectly through wage 8
increases via de facto indexation mechanisms. Thus, the dilemma of choosing the appropriate monetary and exchange rate nolicy to lower inflation and maintain international competitiveness is more relevant than ever before.

# Exchange Rate Policy, Inflatign and the Real Exchange Rata

Until December 1991, Hungary pegged its exchange rate to a basket of 11 currencies, with annually adjusted weights to reflect the direction of foreign trade. Then the peg changed to a basket with weights of one-half USS dollar and one-half ECU. Finally, on August '993 it switched the peg to one-half US dollar and one-half DM. In all cases, it followed a policy of mini-devaluation to compensate for the inflation differential between domestic and foreign prices. In addition, in setting the rate of devaluation, important considerations have been the level of international reserves and the size of capital inflows as was the case in several Latin-American countries pursuing crawling-peg policies in the 1970s.' The need for exchange rate adjustment, particularly in the last two years, was greatiy affected by cross-currencies fluctuations: as the dollar weakened in early 1992, it led to an effective depreciation of tde forint since the acthal share of US dollar trade is lower than one-half, thereby reducing the need for a larger devaluation.<sup>5</sup> In addition, facing rising

# 4See Yuravlivker (1985).

5 The pattem of devaluations in last four years has been the following: 22% in 3 steps in 1989, 5% in 2 steps in 1990, 22% in 2 steps in 1991, and 5.5% in 3 steps in 1992. The sharp drop in exports since late 1992 has led the National Bank to devalue 5 times in 1993 by an accumulated 14% during the first 9 months of this year.

9
inflation rates in 1992, the authorities slowed the pace of devaluztions fearing the potential impact on prices.

The real effective exchange rate (REER) depreciated from 1985 to 1989 and appreciated thereafter. The magnitudes of the changes depend on the definition: deflating by the PPI, the REER depreciated by 25% in 1985-92 but appreciated by 11% in the second **part of that period (1989-92). Using the** industral unit **labor cost as deflator, it depreiated** by **5%** in 1985-92 and appreciated by **23%** since 1989. With the CPI, the **magnitudes** are similar to the latter.

The evolution of inflation in Hungary in the last few years reflect the effect of changes in 'fundamentals' and one-time price shocks. **The** introduction **of the VAT** and some **price** deregulation undertaken in 1988 was accompanied by an increase in CPI inflation from **one-digit level** to 16-17% per year in 1988-89. A jump to a second step - **29%** in 1990 and 35% in 1991 resulted from the extensive liberalization of prices', the reduction in subsidies, higher excises taxes and acceleration in the rate of devaluation (see below). An inLeresting fact of the dynamics of inflation in Hungary is that the Producer Price Index lagged consistently behind consumer prices in the period 1989-1992. In 1992 the **rate** of change of the PPI was only half as high as the rate of change of the CPI. The faster increase in consumer prices than producer prices is a similar phenomenon to other transition economies, may reflect declining consumer subsidies, increasing retail mark-ups and growing prices of services. The relatively large fiscal deficits in 1992-93 were not a major factor in I By end-1991, nearly 90% of consumer prices were market determined, compared to just over 50% in 1985.

10
the inflationary proc4ss since the government was able to finance<sup>them by issuing internal</sup> debt acquired through private savings channeled through the banking system<sup>rather than by</sup> resorting to the use of the inflation-tax. A more systematic attempt at<sup>modelling and</sup> estimating inflation equations in Hungary is carried-out in the next two<sup>sections.</sup> 3. A Simple Model of Inflation.

Modelling price formation in a transition economy like Hungary is not an easy<sup>task.</sup> Transition economics are a blend of different sentors with different behavioral<sup>rules. Firms in</sup> the state sector may follow mark-up pricing while private firms<sup>operating in competitive</sup> markets may be price-takers. At the empirical level, the estimation of<sup>price equations or</sup> other models face the difficulty that the structure of the economy is changing in the transition period. Fortunately, a sample that reflects a period, where a dominant<sup>proportion of prices</sup> are free (market-determined) is already available at a monthly frequency for prices, wages, the exchange rate and money7.

# A Model of Aggregate Demand and Aggregate Supply.

At conceptual level, a basic distinction to be made is between aggregate demand and aggregate supply. The uzaditional socialist economies were economies<sup>that operated in</sup> conditions of permanient excess de.mrand e.g. the<sup>a</sup> Shortage economy"',<sup>in which most</sup> markets operated as "sellers markets". The lack of operation<sup>of the price system, the</sup> 7 Because of the limited observations, estimating models with annual data<sup>will include</sup> both the structure of the socialist period and the transition one.

'See Kornai (1980, 1991).

11
tendency for the enterpiise sector to operate with "soft' budget constraints,<sup>and the existence</sup> of a built-in "investment-hunger" by managers and planners generated,<sup>at an aggregated</sup> level, chronic excess demand in the economy. These disequilibria,<sup>in turn, showed-up as</sup> shortages of final products and inputs, queues, black markets,<sup>low quality products and</sup> forced substitution of final goods by consumers and inputs by producers.

The post-socialist transition changed the picture. One view is<sup>that restrictive demand</sup> policies and the ensuing 'transformational recession" have shifted the r iegime from excess demand and shortages in which output was suppIX determined<sup>(c</sup> rce constrained) to a regime in which output was dmand determined<sup>9</sup> On<sup>thc *</sup> - hand, since the transition renders a part of the existing capital stock<sup>economically obsolete, the</sup> supply side could still be a binding constraint to output expansion<sup>in the medium run. Thus,</sup> in our framework, the price level (or the rate of inflation) and aggregate<sup>output (or the rate</sup> of GDP growth) are both iointly determined by the interplay of aggregate demand factors (money, fiscal variables, the exchange rate) and aggregate<sup>supply factors (wages, the local</sup> price of imported inputs which in turn depends upon the<sup>exchange rate, the rate of</sup> productivity growth). Let us turn now to the main building<sup>blocks of our model.</sup> A-rate supply.

Let us assume that the ecoromy has an aggregate production function, F(.),<sup>in three</sup> factors: labor, L, imported intermediate inputs, IM, and physical<sup>capital, K.</sup> (1) Y = F (L,IM, K) 9 Kornai (1993) argues that in the post-socialist tiansitions suffering<sup>a "transformational</sup> recession" the economy shifted from being "resource (supply)<sup>constrained" to be "demand</sup> constrained".

12
Assuming cost-minimization, the demand for labor will be a function of the real wage, W/P, and the price of imported intermediate inputs EPn*/P and the capital stock, which is assumed to be a fixed factor.

# (2) L= L(W/P, EPnJ/P, K)

The demand for imported intermediate inputs is a function of the relative price of imported inputs, EPn/P, where E is the nominal exchange rate, Pn, is the international price of imported inputs and P is the local price level. The relative price of imported goods thus defined is also the real exchange rate.

# (3) IM =[M( EPn'/P, W/P, K)

Replacing equations (3) and (2) in (1) we get the aggregate supply function, Ys,(e is a supply shift factor)

# (4) Ys = Ys(W/P, EPn*/P, K, e)

Tne level of aggregate output will be a negative function of the real wage and the real price of imported inputs'°.

# Aggregate demand

Aggregate demand, Yd, is equal to the sum of private consumption, C, total investment, I, goverrnment consumption, G, exports, X, minus imports, M.

(5)Yd = C + I + G + X-M 10 We assume, for simplicity, that there is no change in relative prices in dollars between intermediate inputs and an average basket of tradable final goods. The model can be easily expanded to include a more realistic differentiation between the prices of imported materials and energy and the price index of all traded goods.

13
Assuming that consumption is a function of disposable income", investment depends on the real interest rate or directly on the stock of real balances (or credit) and that exports and imports depend on the real exchange rate, domestic output and foreign output, Y*. Assuming equilibrium in the money market (the real interest rate can be expressed as a function of the stock of real balances and the level of income) we can Arrite:

- (6) Yd Yd( M/P, Z, EP'/P, Y, v)

where Z is a vector of fiscal variables, Z={ G, t} comprising governrent consumption, 0, and taxes, t, and v is a demand shift factor. Aggr.;ate demand will be a positive function of the stock of real balances, the real exchange rate, (assuming the tievaluation is expansionary), the level of public consumption and foreign income. In turn, output demanded will be a negative function of taxes.

Figure 2 shows the macroeconomic equilibrium of the system as represented by the intersection of the upward sloping aggregate supply (AS) and the downward sloping aggregate demand (AD) schedules where the vertica axis measures the price level, P, and the horizontal axis the level of GDP, Y. In equilibrium, aggregate demand is equal to aggregate supply and that determines the price level and the level of real GDP for given values of M, E, W and other shifting parameters of the demand and supply functions.<sup>12</sup> : (7) Ys( W/P, EPn/P, K, e) = Yd( M/P, Z, EP/P, Y', v) " It also could be made a function of the level of real wealth.

12 As Bruno (1992) argues the model will need to incorporate two additional equations to determine endogenously the three relative prices of the system: W/P, EP/P and M/P. One possibility suggested is to incorporate the net excess for labor (a labor market) and the net flow excess demand for foreign exchange (the current account of the balance of payments).

14
Solving for the price level we get:

- (8) P = P( W, E, M, q)

In this specification the price level depends both on demand and supply factors, like nominal wages, **the** nominal exchange rate, the nominal money supply. In turn, the factor q includes all the other constants appearing in equation (7). Expressing equation (8) in rates of growth form we obtain the following inflation equation:"

- (9) X = 6P/P = a GWAGE+ b(GE + GP1+ c GM + v This equation shows that the rate of inflation, Tr, ~s a function of:

- the rate of growth of nominal wages, GWAGE.

- the rate of devaluation of the exchange rate plus the rate of international inflation

- GE + GP.

- the rate of growth of the money supply, GM.

* the effect of supply and demand shocks comprised in v = 6VZZ +6q/q.

13 This is an 'equilibrium' rate of inflation in the sense that it is consistent with continuous equilibrium in the goods and money markets. Inflationary expectations are assumed as given.

15
<!-- Start of picture text --> P FlGURE2 AS<br>(Prica Level]<br>| ~~~~~AD [M,E.Zl<br>Y, (Outp u j<br><!-- End of picture text -->

Moreover, for condition of homogeneity in the real aggregate demand and aggregate supply functions, we have that a + b + c = 1.

The model could be extended also to include also indexation rules for wages<sup>and the</sup> exchange rate and an accommodation rule for the money supply<sup>(see Corbo and Solimano,</sup> 1991 and Bruno, 1992, for further elaboration along that<sup>lines).</sup>

# 4. Econometric Estimates.

In this section we present the main results of the estimaticn of inflation equations based on the specification of equation (9) allowing for lags<sup>in the effects of the different</sup> explanatory variables. The sample runs from 1990(1)<sup>to 1992(11) and uses monthly</sup> 16
information. The equation is estimated by Ordinary Least Squares for two price indices: the rate of change of the Consumer Price Index and the rate of change of the Producer Price Index"4. As the product (or input) composition of the two indices is different for producer and consumer prices we should iot expect to obtain the same coefficients for the explanatory variables of the model in the CPI and PPI equations. In general, the CPI includes a larger share of non-traded goods. The appendix provides more information on the construction of the right-hand side variables in the estimation.

# Consumer Price Inflation.

Table 2 presents the estimates of the model for the specification using the rate of change of the CPI as explanatory variables for two versions of the model: one in which the coefficients are unconstrained and another in which the coefficients are constrained to sum one (homogeneity condition). A dummy variable is included to capture the special effects of price liberalization waves introduced in January-February 1990 and 1991.

In the unrestricted specification both the exchange rate (adjusted for international inflation) and the rate of growth of nominal wages are statistically significant at 95 percent. The coefficient of the contemporary variable GE +GP is between 0.34 and 0.38. The sum of the coefficients of that variable for the current and lagged month is over 0.9 in the unrestricted version. The coefficients of the rate of growth of wages in the CPI equation is 14 Simultaneity problems are bound to be less important in the case of Hungary as the degree of wage indexation is low and the exchange rate and monetary policies are not fully accommodating. Moreover, the lack of valid instruments at monthly frequency precludes the estimadon of the model by two Stages Least Squares or Instrumental Variables.

17
about 0. _15-0.17._ When the coefficients of wages of the current period and one and two months lags are added-up the resulting coefficient rises to 0.28 (Table 2, eqn. 1).

The coefficient of current period money growth appears with the wrong sign. The sum of the coefficients with one and two month lag is around 0.40-0.46 for the unrestricted specifications.

Let us turn now to the estimation with the restrictioi, that the coefficients sum one. The parameter of the exchange rate (plus foreign inflation) variable lies in the range of 0.40 - 0.62 depending upon the specification and the number of lags included. This value of the coefficient of the exchange rate shows that a 10 percent devaluation would produce an increase in the CPI between 4 and 6.2 percent, ceteris paribus, say holding wages and money fixed after the devaluation. The coefficient of wages is between 0.20, (specification with no lags) and 0.23 wheii two lags are added up. The coefficient of the sum of two months lagged mo-ney growth (MI) is between 0.40 (eqn. 4, table 2) and 0.44 for the specification represented by (eqn. 7, table 2).

In general these results show that the exchange rate (and foreign inflation) has a quantitatively important impact on CPI inflation. Besides, this variable is the only one that is statistically significant across different specifications. Moreover, the impact of changes in the rate of growth of Ml on CPI inflation is weak in the short term and operates with seveal lags.'5 The rate of growth of wages also has an impact on CPI inflation though its quantitative importance is not very large. These findings suggests that a policy of exchange 15 Unpublished estimations conducted at the National Bank of Hungary suggest that changes in domestic credit have also a large impact on consumer prices.

18
rate based-disinflation is bound to have a bigger short-term impact on reducing inflation than a strategy that relies only on reducing the rate of money growth. These findings supports the notion held by the NBH that the exchange rate nas a relatively large impact on domestic prices and therefore it can be used as a nominal anchor for stabilization. However, further research is needed to gauge the impact of the associated _r1_ exchange rate appreciation (see section _5)_ on exports and import flows and hence on the trade balance.

# Producer Prices Inflation.

The estimation of price equations using the producer price index, PPI, as dependent vaiable yields, in general, weak results and imprecise estimates (see Table 3).

In the unrestricted specifications (equations 1 and 2, table 3) only the sum of exchange rate devaluation plus foreign inflation is statistically significant in the different specifications. The value of the coefficient for the current period value of GE+GP- is around _0.55_ and the sum of the coefficients for this variable plus two lags lie in the range of 0.71 and 0.79. As these equations show, the impact of exchange rate policy on the PPI is xizeable and quicker than on the CPI given the former's larger share of traded goods."<sup>6</sup> The coefficient of the rate of change of nominal wages in the PPI equation is very small and statistically insignificant. The sum of the coefficients of the rate of growth of MI of the current and lagged periods is in the range of 0.33 and 0.39.

> **16** Estimations conducted at the NBH suggests that the full inflationary impact of exchange rate changes may take 3-4 quarters.

19
It is worth noting that on impact, the effect of a change in the rate of devaluation has a greater impact on the rate of inflation measured by the PPI than the rate of inflation of the CPI. This result is consistent with the lower rate of inflation of PPI than CPI observed in Hungary in the last few years.

20
||GWAGX|________,<br>GWAGE4-I)|CWAGV44)|_GE+Co_|"I3*A<br>Depd<br> <br>GE.I)C?Rt|XLY.,*5W1UA<br>_Vsibh_<br>lXi'dC1m<br>GlM4GV4|T3OeS<br>meeJCM.--<br>G1i|_Gul-I)_|'-'--<br>GV(- -'<br>.|-<br> <br>NCW|_m-o_|C-2)|It|DW|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|| nrdrit|_____|||_<br>_<br>_<br>_||~~~~~||<br>~<br>~|<br><br>~~~~~~|<br> <br>~~~~~|<br>2)--|.,.|,|..|
|cc_:<br>EQI|S0541|005||*||'|||||||||
||.<br>4272)|.<br>120|0.042<br>064|0.319<br>51|0.354<br>|0.202<br>|-0.21<br>|0 116<br>|*.2<br>|4.011<br>|||069|1.27|
|EQ2|.<br>014S-|(.)|(.)|(073)<br>0317'|(176)<br>0349|(2.36)<br>0169|(3.96)<br>|(1.16)<br>'|(3713)<br>'|(-.MI)<br>|||||
||.<br>|||<br>|.-<br>|-|-0e1<br> <br>|0.17<br>|021.n<br>|-8.003<br>|||066|i.20|
|@ E3|(326)|||(5.33)<br>*|(2.06)||I.9<br>-3..9)|(2.26)<br>|(4-.<br>|(-0.14)|'||||
|_ Q||||0.343||||0.334|0.114||0.123||||
|**Daeiride**<br>|'|||(546)<br>||||**(3.33**<br>|((7.60)<br>||||||
|FM4|0.129<br>|0.067<br>|0.031<br>|0.334-<br>|-0.028<br>|0.85'<br>|-0I.121<br>|0.318<br>|6.215|S.A<br>|||092<br>_n_|17|
|EQS|_a.303)_<br>02040|(0.e)|(0.49)|(4.15)<br>'|(-0.20)|(1.93)|U-1L0M)<br>|(1.66)||(2a43)<br>'|||||
||.<br>|||0.623<br>|||0.173<br>|||6.033<br>|||0.74|1.56|
||(2.47)|||0.U3)<br>|||(2.39)|||(2.29)|||||
|EAq)6<br>Ei||||0.40'<br>(5.25)<br>||||'||4.012<br>(-1.35)<br>|**0.694**<br>**(3**22)||0.89<br>|1.12<br>|
|Q||||0.564<br>t(30)|||00.95<br>_(_39)|0.346<br>(366)||0010<br>4033)|||036|**A4S**|

t - Si6c tad,r pamstoib

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|||_WAc-_|_GWAGF;4.I)_<br>':i'i:t;..0<br>".003'|GWAGF.-2)<br>-,',<br>0.01<br>0.54|_GC4IG_<br>-(<br>.|_Go(-lu(-_<br>I(.I)<br>014|_|_|_aut..-_<br>_.c_|_Ii)_||Ge|DUMUY|le|D.W.|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|tv)|EQI|oA46<br>(0.48)|o.oos<br>(0.041)|00072<br>(0.59)|o-.4<br>(4.1|0314S<br>(0.39)|o.on<br>(0.81m)|5.e3s<br>do.3i)|0.194<br>(3.10)|0.04<br>(0.73)||0o013<br>_(e n)_|0 51|1 25|
||EQ<br>EQ3|PA.05S<br>(0 67)<br>0.038|4.00!|0.069|0.5553<br>(4.35)<br>0.519|0.230<br>(0.602)<br>-0 006|0.016<br>(0.122)<br>002|0.03)<br>(0.27)<br>|0.235<br>(3.77)<br>|s.120<br>(3.03)||-o.oo.<br>( 0-02s)|050|1.16|
|||(0-40)|-0.011)|(0.31)|(4.13)|<br>(-0.03)|.<br>(013)|0.071<br>|0.211<br>|0.073||0 031|79|i13|
||EQ4|0.058<br>so.69|||||.|(0.40)<br>2|(1.30)|||(1.022)|||
|||(0066)|||(..25)|||0o53<br>||||0019|0 6<br>|1.)3|
||EQS||||0.65f'|||(3.03)<br>||||(113)|||
||||||(7-___<br>.8S)__|||0.254|e.f.l<br>(2.3S)||0.374-<br>(2.75)|-0019<br>1.25)|_o.n_<br>|_L.7_|

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> * 5.nmca _5*95 peud_ Icvct
# 5. Policy Options for Disinflation: Simulation Results.

To explore more systematically different strategies of disinflation that are relevant for Hungary, we use the estimates of the model to simulate four types of disinflation options.

The options explored contrast policies of money-based stabilization with exchange rate-based stabilization besides mixed strategies and an exchange-rate policy oriented to keep the real exchange rate constant in presence of inflation.

In general, the difference between exchange rate versus money-based disinflation lie in the distribution over time of the costs of stabilization and the transmission mechanisms through which the price level and output are affected by each stabilization strategy.

In general, money-based stabilization tends, to generate a recession in the short term as tight money rise real interest rates and cut domestic absorption. Clearly, the costs of disinflation are paid at the beginning of the program. In contrast, exchange rate-based stabilization programs may, in principle, avoid a recession or even produce an initial boom in economic activity (see Kiguel and Liviatan, 1992). In fact, the usual pattem in an exchange rate-based stabilization program is a fall in real interest rates and a real appreciation of the exchange rate because price inertia and wage stickiness. If the real interest rate effect dominates a recessien can be avoided in the short-term. However, the real currency appreciation in the medium run will have a recessionary effect as domestic output becomes less competitive in international markets. Thus, the costs of stabilization tend to be postponed over time in programs using the exchange rate as a nominal anchor.

23
Regarding the effect on the price level, a money-based program<sup>acts, chiefly, by</sup> creating slack that moderates both wage increases in the labor<sup>market and price changes in</sup> the goods market.

Moreover, in exchange rate-based stabilization programs, the<sup>nominal exchange rate</sup> exerts a moderate effect on the price level though several<sup>channels: it reduces the rate of</sup> increase in the domestic price of imported intermediate inputs,<sup>it slowdown the rate of</sup> increase of imported final goods (chiefly consumption goods) and<sup>indirectly it reduces the</sup> rate of growth of wages if they are indexed to the CPI." Most of these effects are already included in our inflation model<sup>and are reflected in</sup> the elasticities of aggregate demand and aggregate supply with<sup>respect to the money supply</sup> and the exchange rate. Our price estimates are thus function<sup>of those structural parameters.</sup> The four strategies of disinflation that are simulated for the period<sup>1991(1) to</sup> 1992(11) are": (1) A policy of fixing the nominal exchange rate, GE=0 (Simulation<sup>1).'9. It is</sup> assumed that this policy is crecible to the public and<sup>that is backed by a sufficient level of</sup> international reserves at the Central Bank.

17 See Dombusch (1986), Sachs and Larmain (1993), ch.<sup>15.</sup> " The simulation starts on 1991(1) to take into account the period<sup>in which most basic</sup> misalignment in relative prices were corrected and the economy<sup>operated more or less under</sup> a regime of free prices.

19 A simulation of this policy with a full macro-model would<sup>include the estimation of a</sup> money demand equation and also the capital account, sae<sup>Fischer (1984). Alternatively, it</sup> could be assumed that the monetary authorities sterilize any<sup>additional increase in the amount</sup> nf monev resultine from inflows of reserves.

24
(2) A policy of reducing the rate of growth of MI to 1 percent per month (Sim. 2).

(3) A combined policy of fixing the exchange rate and reducing the rate of growth of the money supply to a rate of 1 percent per month, GE =0 and GM1 = 1 percent (Sim.3)<sup>2</sup> ".

(4) A policy of devaluing the exchange rate at a rate equal to the difference between (last month) domestic and foreign inflation (Simulation 4).

These policies, in turn, are evaluated in terms of two criteria (see tables 4 and 5): . Velocity and magnitude of disinflation.

• Impact on the real exchange rate.

This illustrates a basic dilemma in stabilization in open economies that use the exchange rate as a nominal anchor for disinflationazy purposes: namely that disinflation might be bought at the price of a real appreciation of the exchange rate that affects external competitiveness, the development of the export sector and possibly the attainment of current account targets.

Simulation 1 amounts to a strategy of exchange rate based stabilization, simulation 2 is a strategy of money-based stabilization and Simulation 3 is a combination of Simulations i and 2. Simulation 4 amounts to a PPP (purchasing power parity) rule seeking to maintain a constant ra1 exchange rate. This last policy is oriented to preserve external balance and promote exports rather than reduce inflation. Though, it is still worth exploring the inflationary implications of this policy.

**20** This simulation assumes that the monetary authorities can impose restrictions on capital mobility in order to delink domestic from international interest rates.

25
Table 4 reports the results of the path of CPI inflation<sup>21</sup> associated with each of the four policy simulations just described. Moreover, a base simulation is also presented using the actual values of the right hand side variables of the model. The regression coefficients used in the different simulations correspond to equation 5 (restricted specification) in table 2. As it can be seen from table 4, the simulation that combines a fixed nominal exchange rate with reduced money growth (sim. 3), is the one that yields the lowest inflation rat: 1 percent per month which amounts to an annualized rate of 12.9 percent. This implies a reduction of near 10 percentage points of inflation per year compared to the base simulation (see bottom table 4). In simulation I (fixed exchange rate) the monthly rate of CPI inflation is 1.2 percent with an annual rate of 15.4 percent. In turn, a policy of money-based disinflation, GM1 = 1 % per month, (simulation 2) yields a monthly rate of inflation of _1.5_ percent with a corresponding annual inflation rate of 19.8 percent. Finally a PPP based exchange rate rule gives a rate of inflation per year of 36 percent; substanially higher than the inflation rate associated with any other simulation, included the base simulation. 22 Table 5 shows the evolution of the real exchange rate, defined as EP/P, associated with each simulation. The results show that the degree of real exchange appreciation is greater for the policy of fixing the exchange (simulation 1) than for any other policy simulation. In simulation 1 (exchange rate-based clisinflation) the cumulative real appreciation from 199 1(1) to 1992(11) is 24.3 percent and in simulation 2 (money-based 21 Since the estimates for PPI were rather unstable we preferred to simulate the effects of the different policy rules on CPI inflation.

22 The question of what price index to use when pursuing a PPP rule is not trivial, particularly when the rate of inflation of various indices are relatively different, as is the case in Hungary. Here the CPI is used as indexer for consistency to obtain dynamic simulations since the CPI equation is more stable than the PPI equation.

26
stabilization) the cumuladve appreciation is 16.4 percent. As it could be expected the policy of PPP rule is the only rule consistent with a constant real exchange rate at the end of the simulation period.' Clearly, the simulations illustrate the orders of magnitude of the implicit trade-off between using the exchange rate for anti-inflationary purposes (simulation 1 and 3) instead of gearing it to smi exchange rate targets (simulation 4). When the exchange rate is used for stabilization the disinflation is quicker but it is accompanied by a **larger** real appreciation of the currency. In contrast, a PPP rule avoids a real appreciation and maintains a stable real exchange rate under (moderate) rate of price level increases, though, at the same time, it introdiuces an 'inflationary bias5 in the system through a policy of persistent devaluatione4 3 Since these are counterfactual simulations, we implicitly assume the absence of any =LI shock (terms of trade, productivity) during the simulation period that would call for an adjustment of the real exchange rate.

24 In this .nod1e we have not included explicitly the existence of wage inclexation to the CPI. In that case, the inflationary impact of a PPP rule or any change in the rate of devaluation or in the level of the nominal exchange rate would be larger since it would entail also an acceleration in the rate of growth of nominal wages.

27
TABLE 4 HUNGARY. INFLATION RATE UNDER ALTERNATIVE EXCHANGE RATE AND MONETARY RULES

|||CPI Inflati<br>|on<br>|||
|---|---|---|---|---|---|
||Baa|SIM.1|SIM.2|SIM.3|SIM.4|
|1991.01<br>|6.7<br>|6.7|6.7|6.7|6.7|
|1991.02<br>|4.9<br>|_5.5_|4.8|5.4|8.2|
|1991.03<br>|1.2<br>|012|1.2|0.3|4.1|
|1991.04<br>|1.6<br>|0.9|1.6|0.8|3.3|
|1991.05<br>|_1.5_<br>|0.8|1.1|0.4|2.9|
|1991.06<br>|_0.5_<br>|0.3|_0.5_|0.3|1.7|
|1991.07<br>|1.1<br>|1.0|0.8|0.7|2.0|
|1991.08<br>|.0.4<br>|-0.9|_-0.5_|-0.9|1.0|
|1991.09<br>|1.9<br>|1.2|1.9|1.2|1.2|
|1991.10<br>|1.1|0.4|1.1|0.4|2.0|
|1991.11<br>|_4.5_<br>|3.8|3.9|3.2|2.4|
|1991.12<br>|2.1<br>|2.0|0.6|_0.5_|2.6|
|1992.01<br>|40.6<br>|-0.7|-0.0|40.1|0.6|
|1992.02<br>|_0.9_<br>|0.3|1.0|0.4|2.7|
|1M.03<br>|3.6<br>|1.1|3.5|1.0|4.S|
|1992.04<br>|0.8<br>|1.3|_0.5_|0.9|1.3|
|1992.05<br>|_0.5_|0.3|_0.5_|0.3|1.2|
|i992.06<br>|1.3<br>|0.8|0.9|0.4|2.0|
|192.07<br>|2.8<br>|2.0|2.4|1.6|1.7|
|1992.08<br>|-0.7|-0.3|-1.1|-0.7|0.4|
|1992.09<br>|0.9|_0.5_|0.8|0.4|1.2|
|1992.10<br>|0.3<br>|-0.0|0.3|-0.0|2.0|
|1992.11|2.7|_0.5_|2.4|0.2|4.3|
|Monthly inflation|1.7|1.2|1.5|1.0|2.6|
|ntte(ar nage percent)||||||
|Annualized||||||
|inflation rate<br>(percent)|22.5|15.4|19.8|12.9|36.0|

28
TABLE _5_

# HUNGARY. REAL EXCHANGE RATE UNDER ALTERNAITIVE EXCHANGE RATE AND MONETARY RULES

||BASE|SIMULl|SIMUL2|SIMUL3|SIMUL4|
|---|---|---|---|---|---|
|1991.01<br>|100.00<br>|100.0<br>|100.0<br>|100.0<br>|100.0<br>|
|1991.02<br>|97.2<br>|94.4<br>|97.5<br>|94.7<br>|98.1<br>|
|1991.03<br>|96.5<br>|93.8<br>|96.4<br>|93.9<br>|99.6<br>|
|1991.04<br>|93.2<br>|93.0<br>|95.6<br>|93.2<br>|101.2<br>|
|1991.0S<br>|93.4<br>|91.9<br>|94.6<br>|9?.9<br>|101.0<br>|
|_1991.06_<br>|93.0<br>|91.7<br>|94.1<br>|92.6<br>|102.5<br>|
|1991.07<br>|90.7<br>|90.7<br>|93.8<br>|92.2<br>|102.7<br>|
|1991.08<br>|90.3<br>|90.2<br>|92.8<br>|91.8<br>|101.9<br>|
|1991.09<br>|89.3<br>|90.0<br>|92.2<br>|91.5<br>|104.0<br>|
|1991.10<br>|88.8<br>|89.8<br>|91.2<br>|91.4<br>|103.1<br>|
|1991.11<br>|88.3<br>|86.0<br>|91.7<br>|88.6<br>|101.6|
|1991.12<br>|88.8<br>|82.4<br>|91.6<br>|87.7<br>|99.1|
|1992.01<br>|91.5<br>|83.1<br>|91.2<br>|87.3<br>|102.3<br>|
|1992.02<br>|87.2<br>|83.2<br>|90.3<br>|87.1<br>|103.4|
|I992.03<br>|83.6<br>|82.2<br>|88.3<br>|86.2|101.2|
|992.04<br>|85.0<br>|d0.9<br>|88.7<br>|_85.5_<br>|102.3<br>|
|i992.0S<br>|84.7<br>|80.6<br>|88.2<br>|85.2<br>|103.0|
|1992.06<br>|82.7<br>|79.5<br>|87.6<br>|84.7<br>|102.4<br>|
|1992.07<br>|83.0<br>|77.4<br>|87.4<br>|83.1<br>|101.4<br>|
|1992.08<br>|84.4<br>|77.1<br>|87.0<br>|83.4|102.2|
|1992.09<br>|83.0<br>|76.5<br>|86.4<br>|82.9<br>|102.7<br>|
|1992.10<br>|81.3<br>|76.4<br>|85.8<br>|82.8<br>|103.2<br>|
|1992.11|77.2|75.7|83.6|82.5|100.8|

29
FIGURE 3 HUNGARY: **CONSUMER** PRICE INDEX **(Simulated values** under altemative stabilization **strategies)** <!-- Start of picture text --> 240,<br>220 4 20 W ~~~~~~~~~~~~Simulation 4/<br>200<br>1801<br>160- Simulation 2<br>140 1<br>120j<br>-<br>100 '!'<br>-1991.01 1991.04 1991.07 1991.10 1992.01 1992.04 1992.07 1992.10<br><!-- End of picture text --> 30
FIGURE 4

# HUNGARY: REAL EXCHANGE RATE (Simulated values under altemative stabilization strategies)

<!-- Start of picture text --> 105<br>1005- Simulation 4<br>95<br>90 - Simulation 2<br>90mulati I<br>85<br>so ~~~~~~~~~~~~~~~~~~~Simulation 3<br>75<br>1991101 1991.04 1991.07 1991.10 1992.01 1992.04 1992.07 1992.10l<br><!-- End of picture text --> 31
# 6. Concluding Remarks

This paper has explored, empirically, the inflationary process in Hungary, and provided econometric estimates of the determinants of CPI and PPI inflation for the period 1990-1992 using monthly data. The empirical estimates of price equations -both CPI and PPI- show the quantitative importance and statistical significance of the exchange rate in the process of price formation in Hungary during the period of intensification of reforms (price liberalization while the economy becme more open to international trade of final goods **and** inputs). Our estimates show that the money supply affects consumer and producer prices with several lags and its impact on prices is small in the short run. Moreover, nominal wages have a more significant effect on the CPI than on the PPI.

The paper presents illustrative policy simulations of alternative rules for the exchange rate and the money supply in terms of their impact on the rate of inflation and the level of the real exchange rate. It is found that a rule of fixing the exchange te entails a lower level of CPI inflation -some _5_ percentage points of less CPI inflation per year--than a rule based on reducing the rate of money growth (to 1 percent per month). However, a fixed exchange ate policy is associated with a larger appreciation of the real exchange rate than a policy of money based disinflation-nearly 4 percentage points more of real appreciation per year. In tum, a PPP based exchange rate rule stabilizes the real exchange rate at the cost of a substantial acceleration in inflation.

In this way, these exercises illustrate the nature and magnitude of the trade-offs between faster disinflation and the level of external competitiveness in an open economy like Hungary that uses the exchange rate as a nominal anchor in disinflation.

32
Areas of further policy interest that require more analysis in the future refer to the causality between real appreciation and capital inflows, the process of wage formation in the transition period and the channels through which changes in the real exchange rate affect trade flows, spending and output.

33
# ReferXnces

M. Bruno (1992) 'Shocks and Accommodation: The Dicothomy and Mechanics of High Inflation' mimeo.

V. Corbo and A. Solimano (1991) 'Chile's Experience with Stabilization Revisited' in M.

Bruno sL (eds.) Lessons of Economic Stabilization and Its Aftemath MIr Prcs. S. Commander and F. Coricelli (1992) 'Price and Wage Dynamics and Inflation in Socialist Economies: Empirical Models for Hungary and Poland' in The World Bank **_£=_** icRde January, Vol. 6, #1.

R. Dornbusch and S. Fischer (1993)'Moderate Inflation' The World Bank Ecnomic Review Jan, 7, 1-44.

R. Dornbusch (1986) 'Inflation, Exchange Rates and Stabilizaton' Princeton Essays in International Finance. #165, Octcber.

A. Solimano, 0. Sunkel and M. Blejer 1993 (eds), Rebuilding Capitalism. Alternatve Roads after Socialism and Diri&me. The University of Michigan Press (forthcoming). S. Fischo.r(1984) 'Real B.Lances, The Real Exchange Rate and Indexation: Real Variables in Disinflation' NBER Working paper # 1497.

M. Kiguel and N. Liviatan (1992) 'The Business Cycle Associated with Exchange RateBased Stabilization' The World Bank Economic Review. Vol. 6, 2, May. J. Kornai (1993) "Transformational Rccession. A General Phenomenon Examined Through the Example of Hungary's Development". Francois Perroux Lecture. Discussion Paper # 1. Collegium Budapest. Institute for Advanced Study, Budapest, Hungary.

34
R. Pindyck and A. Solimano (1993) 'Economic Instability and Aggregate Investment' PRE Worlcing Paper # 1148 and 0. Blanchard and S. Fischer (eds.) in NBER Macroeconomic Annual, 1993.

J. Sachs and F. Larrain (1993) Macroeconomics. In the Global _Economy._ Prentice-Hall.

A. Solimano (1991) ' Economic Transformation in Eastern and Central Europe: An Historical and International Perspective', Ch.l in V. Corbo et.al. Rformingl and Rastern Erg= EcnoMies. Initial Results and Challenges.A World Bank Symposium.

- (1993) 'The Post-Socialist Transitions in Comparative Perspective: Policy Issues and Recent Experiences' World Development Vol. 21, # 11, November (forthcoming).

D. Yuravlivkcr (1985) 'Crawling Peg and the Real Exchange Rate - Some Evidence From the Southern Cone", Journal of D2evelopment Economics 18: 381-393.

_35_
# Ammwdix

## Construction of the Variables

- GPPI Rate of change in the Producer Price Index. Source: Cental Statistical Office.

- GCPI Rate of change in the Consumer Price Index. Source: Centa Statistical Office.

- GE Rat of change of L%a exchanp mte.

- Mhe exchange rate is a weighted average index constructed as: (0.5) 0 Fotint/USS + _(0.5)_ * Forint/ ECU. Source: Nadonal Bank of Hungary.

- _GP_ Ratc of change of the index of wholesale prices of Hungary's main triding partners. Source: National Bank of Hungary.

- _GMI_ Rate of change in the stock of currency outside banks, enterprise deposits, household deposits, and other liquid deposits. Source: National Bank of Hungary.

- GWAGE Rate of change in the index of average manufacturing wages. Source Cental Statistical Office.

- DUMMY The dummy variable equals I in January and February of 1990 and 1991. For all other months it equals zero.

The indices, are escalated to December 1990 = 100.

All the series are monthly data collected from the Hungarian Cental Statistical Office and the National Bank of Hungary. However, prior to 1992, wage data was only on a quarterly basis. We have interpolated the quarterly wage data through December 1991 to get monthly wage series for the pre-1992 perod.

36
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