metadata: authors: 0: author: Conway,Patrick J.
count: Europe and Central Asia
docna: 0: docna: Sustained inflation in response to price liberalization
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Sector Economics,Competition Policy,Inflation,Energy Demand,Energy and Environment,Energy and Mining,Competitiveness and Competition Policy,Public Finance Decentralization and
            Poverty Reduction,Financial Sector Policy
teratopic: International Economics and Trade
abstracts: cdata!: The author demonstrates that sustained
            inflation is a predictable response to price liberalization
            in the countries of the former Soviet Union. The author
            models the phenomenon in a dynamic macroeconomic framework,
            and demonstrates the immediate price jump followed by
            sustained inflation that has characterized the transitional
            economies of the former Soviet Union. The author supports
            the theoretical derivation with a simulation exercise that
            demonstrates the scope of sustained inflation for specific parameters.
repnme: repnme: Sustained inflation in response to price liberalization
display_title: Sustained inflation in response to
            price liberalization
listing_relative_url: /research/1994/10/697980/sustained-inflation-response-price-liberalization
topicv3: Price Controls m1326085 2107,Energy and Extractives m1326595 507,Fiscal Consolidation m1326651 1116,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Europe Eastern:Ukra/Moldov/Belar (ECCEE)
no_of_pages: 30
author_keys: 0: author_key: 390741
model_extractions: 1 POLIcy RESEARCH WORKING PAPER 1368

# Summary findings

Conway demonstrates that sustained inflation is a predictable response to price liberalization in the countries of the former Soviet Union. Hc models the phenomcnon in a dynamic macroeconomic framework, and demonstrates the immediate price jump followed by sustained inflation that has charactcrized the transitional economics of the former Soviet Union.

He supports the theoretical derivation with a simulation exercise that demonstrates the scope of sustained inflation for specific parameters This paper-a product of the Country Operations Division 2, Europe and Central Asia, Country Department IV-is part of a larger effort in the region to study financial sector and macroeconomic policies in transition economies. The study was funded by the Bank's Research Support Budget under the research project 'Ruble Shortage Phenomenon in Members of theRuble CurrencyZone" (RPO 678-08). Copiesof thispaper are available freefrom theWorldBank, 1818 HStrectNW, Washington DC 20433. Please contact Lenora Suki, room H2-096, extension 33974 (25 pages). October 1994.

_The Policy Research Workig Paper Sris dissmates the Iindng of work_ vr _procss to enwzurage the exag of das about development ssus.An objctis of the series is toget the fidns ot quikly, evn if dte pre aom are lssr tha fidky polsheeL 7c papers cany the nams of thc athr and_ **_sMdbeI_** _used and died accordngly. The fmdzgs, hzerprnation and condusions are the authors' own and should not be attributed to the World Rank its Executive Boad of Dimactors or any of its member comsteL_ Produced by the Policy Research Dissemination Center
# Sustained Inflation in Response to Price Liberalization

Patrick Conway Department of Economics CB 3305, Gardner Hall University of North Carolina Chapel Hill, NC 27599 conway.econ@mhs.unc.edu Thanks to Stanley Black for detailed comments on a previous draft, to Wafik Grais and Chandrashekar Pant for helpful discussions on these issues, and to Ricardo Martin for his constructive criticism of earlier work-
Susained **lnaadon** - 2 The countries of the former Soviet Union have experienced sustained inflation in the period since independence. Although a burst of inflation was widely anticipated as a response to the "ruble overhang" buDt up in the final years of the Soviet Union, the subsequent price inflation has been more rapid and sustained than expected.

There are a number of causes for this sustained inflation: continuing budget deficits in these countries financed through the inflation tax, increases in prices of energy and other imported intermediate inputs, and more recently the establishment of inflationary expectations. In this paper I demonstrate that removal of the "ruble overhang is not an instantaneous outcome in a forwardlooking economy, but rather will generate a- sustained inflation independent of changes in these other factors. Sustained inflation is thus a predictable market outcome in response to an initial price liberalization. The reason lies in the interaction of private saving responses to inflation and the government's resulting altered reliance upon the inflation tax to finance its expenditures.

In the first section I present the history of the "ruble overhang" and subsequent ruble shortages in the former Soviet economies. I also illustrate the problem of sustained inflation in these economies through examination of historical data for a number of republics. In secion II I construct a simple dynamic model of private wealth accumulation and inflation. I demonstrate that the model has a steady state equilibrium, but exhibits saddlepath stability. Adjustment along the saddlepath from ar position of "ruble overhang" is characterized by an initial price jump followed by susained inflation. A numerical example is examined to illustrate the logic of the adjustment process. Section MII includes conclusions and possible extensions to the analysis. The logic of the adjustment process is examined as well to consider the possibility of an explosive dynamic.
**Susmined Innaon-** 3

# I. From Ruble Overhang to Ruble Shortage.

The Soviet Union of the late 1980s was characterized by price controls, government budget deficits and an allocation of resources disproportionately to national defense and producer-good output. As Nordhaus (1990) reports, this led to shortages of consumer goods, repressed inflation and an undesired build-up in household holdings of liquid assets. The ratio of household liquid assets to household income rose from about .60 in the 1970s to about .95 in 1989.' McKinnon (1991) provides an alternative view of the build-up of this overhang through the 1980s, and notes the positive correlation with the Soviet budget deficit. His figures are provided in Table 1. Prior to 1986 household saving deposits rose at a roughly one-for-one rate with the government budget deficit -the Soviet government was simply using the financial sector and the government budget as a means to channel resources into government investment. Subsequent to that time the budget deficit totalled much more than the increase in saving deposits, with the balance being made up through monetization. Despite noney creation during the 1987-1989 period that approached six percent of GNP annually (and the forced nature of at least some of the household deposits), price controls ensured that retail inflation rates never exceeded two percent per annum.<sup>2</sup> Commentators worried about the inflationary impact of price liberalization in this context. Solutions suggested can be organized into 'supply-side' and "demand-side" policies. On the demand side, McKinnon (1991) suggested the raising of interest rates on deposits to convert forced saving into desired saving and to encourage the reduction in currency boarding. On the supply side, proposals included the exchange of government assets and gold holdings for the excess currency and deposits.

**1** In economies with greater financial development the government will finance budget deficits through issuing bonds. In the Soviet Union the government used the banking system as the intermediary to channel resources to the government, and household deposits in the commercial banks (in addition to hoarding of currency) became claims on the government.

**2** Dornbusch (1992), Table 1.
**Suaind Inflati** - 4

In January 1991 the Soviet government undertook a draconian supply-side policy by declaring large-denomination bank notes to be no longer legal tender. Holders were allowed to exchange them -for smaller bills up to a maximum governed by a worker's monthly salary or a fixed quantity, whichever was less. Household saving accounts were frozen, with individuals allowed to withdraw only 500 rubles per month.' The republics softened these regulations somewhat in subsequent actions. The net impact of this reform on inflation is by no means clear: although money broadly defined is lessened. so also is confidence in these stores of value. The velocity of expenditure almost certainly rose in consequence.

In 1991 the aggregate fiscal deficit of the members of the Soviet Union reached 26 percent of GDP.<sup>4</sup> Inflation reached previously unimagined rates: 142 percent on retail goods and 236 percent on wholesale products. This intlation induced the government to provide transfers to wage-earners, pensioners and savers to index partially the value of their incomes and financial assets. However, due to a lack of goods and services the households retained the income in forced saving of deposits or currency holding. The real value of household deposits was reduced somewhat by the inflation, while the ratio of currency in circulation to GDP remained nearly constant.

The former republics of the Soviet Union cooperated nearly unanimously on the liberalization of the majority of wholesale and retail prices on 2 January 1992. Those prices not liberalized were nearly all raised by between 300 and 500 percent. Given the repressed inflation of the mble - overhang, prices jumped rapidly in the first three months of 1992 retail prices rose by 600 percent and wholesale prices by over 1000 percent This rise in prices greatly reduced the value of nominal assets like savings deposits and currency: by the end of January 1992 the ratio of money broadly defined to GDP had fallen to less than 20 percent.

- 3 These details are reported in McKinnon (1991, p. 157).

lThe information in these two paragraphs is drawn from World Bank (1992).
Sustained **Infiia** - **S** The ruble overhang was followed by widespread cash shortages during 1992 and 1993 in the - ruble zone. However, the inflationary burst was not halted these countries have experienced sustained inflation throughout the period to the present. Table 2 presents the inflationary record of a number of these countries and indicates the sustained nature of the inflation. After the inflationary burst associated with price liberalization inflation continued to erode tie real wealth of savers.

II. A Macroeconomic Model of Inflation, Wealth and Private Saving.

I consider an economy with government, state enterprises and a private sector. The government is combined with the state-enterprise sector in the analysis, with the amalgam referred to as the - public sector. There are a large number of transactions within the public sector purchases of goods - from state enterprises by the government, payment of taxes by state enterprises but only its net position vis I vis the private sector is considered here.<sup>5</sup> The private sector is represented by its net position relative to the banking sector: its real saving decision.° Private saving behavior.

Private real saving behavior summarizes the real resource allocation decision for the private sector. It is income net of consumption and taxes, and can be represented as the behavioral equation

# (-1)

s= S(i-t,Y/P,OIP) SI > O, S > O, **S3** O s As a result, I neglect questions relating to interenterprise arrears. Ickees and Ryterman (1992) provide a detailed discussion of this phenomenon. It has similar characteristics to the Ocasb shortage" problem and I hope to address it in ftiure work.

I thus ignore other important repositories of private saving in the trasitional economies, including foreign exchange holdings and hoarding of goods. I examine the importance of these in more detail in Conway (1994 a,b).-
# **Sudsiod Inoad -6**

- nominal interest rate fi) and the expected inflation raw _(-_ E(dP/P), with E(.) the expecmtionsatr) combine to form the real interest rate on saving instument. The aggregate price index is en by P, while _YIP_ is real income and QWP is the real accumulated wealth of the private sector.<sup>7</sup>

ring is rising in the real interest rate, while rising as well with real income and falling with umulated assets.' ex ante There is in general a distinction between ex ante and ex post saving behavior. _Saving_ ex resents the saving behavior predicated upon last period's price index, while saving post is based in the value of the price index that yields equilibrium in the current period.

Expectations.

Actors are assumed to have perfect fbresight in what fbllows. The expeced inflation rate is s equal to the observd inflation rate.

S0 is _the_ stock of nominal assets held -by the households, and will indude both financial depoits currency holdings.

-Saving is ising with the real interest rate in most theoretidcal derivations; see, for example, nchard and Fischer (1989) and Campbell (1988) for utiity-maxim g derivations im a variety of retical models and McKinnon (1973) for a more heuristic explication relevan **t** o developing countries. **_....1** : _ * :_!__ _ _ ___* -_ __'___ _ e___ _ _
Suuined **Infation -7**

# Public-sector deficits.

The net public-sector position is one of a real budget deficit denoted by (g-c(P)). Publicsector expenditure (g) is thus on private-sector goods and services, with the wage bill a large component; tax revenues (t) include purchases of public goods and services by the private sector. These revenues are assumed to be declining in real terms with the price level (P), with the elasticity of this 'buoyancy" effect defined E = (;rP/t) < 0.9 The government finances its deficit through the issuance of accounting credits (CR).

(3) _g-t_ (P) = ACR/P The private sector can pay taxes in accounting credits.

The national income and product identity in real terms implies that ex post: (4) g - t(P) (s-j) - b When private saving is considered net of private investment (j) it is one channel for public deficit finance. The other is a deficit (-b) on the current account. In keeping with the historical record, opportunities for private physical investment and intemational trade are treated as negligible in what follows. Their introduction does not change the qualitative conclusions of the analysis. Intermediation by the banking sector.

Private saving is thus the dominant source of finance for public-sector deficits. This occurs in a non-inflationary setting through the intermediation of the banking sector. This sector is defined to ' This paper ftbows the convention that subscripts indicate partial derivatives.
**Susinmd Iann. -**

include both the central bank and the commercial banks. Its balance sheet can be represented in stylized form as tollows:

# _(5)_ CR H + D

The banking sector holds as assets the accounting credits (CR) of the public sector. As liabilities it holds both currency in circulation (H) and deposits by households at commercial banks (D). With an increase in accounting credits, the banking sector will either increase currency in circulation or increase the private sector's holdings of deposits (in accounting credits).

The budget deficit can also represent a cash-flow constraint on the economy. If payments g to the private sector (wages and pensions, for example) must be conducted in currency, then in any period the banking sector must be able to convert ACR/P in accounting credits into cash. The banking sector can provide that amount either through increasing the quantity of currency- in circulation (AH) or attracting private-sector deposits of currency that are held on the banks' books as accounting credits (AD).'<sup>0</sup> The Evolution **of** Private Wealth and Inflation.

The private sector has accumulated a nominal stock of wealth (0). Real private saving and interest earnings on nominal wealth augment the stock of real accumulated wealth.

# (6)

# AOIP **=** iWP + s

**10** This places an added constraint on the make-up of the budget. If _6g_ is paid out in currency, then by the banking-sector balance sheet and the budget deffcit condition it is also true that (1-6)g t(P): government expenditures in accounting credits are financed through taxes paid in accounting credits. This does not appear to be a restrictive implication of the model.
Susimd **lnfiSino-** 9 I model the rate of inflation as a response to a simple tatonnement rule in excess demands for goods and services. The dynamic can be stated for j **=** b = 0.

(7) ir AP/P = ((g - t(P) - s) - ' >0 When private saving is insufficien **t** o cover the budget deficit for constant P, the government uses its "first-purchaser" advanage to finance expenditure through credit creation. This leads to price increases as the private sector must bid for the consumption of a decreased stock of resources.

Steady-state Equilibrium.

Equations (6) and (7) define the dynamic processes in nominal asset accumulation and prices for a given level of the budget deficit. Nominal income (Y) and the nominal interest rate (i) are held constant for simplicity.

Equilibrium values of P and S can be characterized trough imposition of appropriate steadystate solutions. First, real wealth is assumed constant in the steady state. Second, price stbility is modeled by setting AP = 0. These conditions generate loci in n and P as represented in Figure 1.

AA represents the combinations of Q and P that assure saving equilibrium; its upward slope represents the steady-state condition that s = -iQ. GG represents the combinations that ensure price sbility; it -can take either slope, but will be less steep than the AA curve.'<sup>1</sup> 11 Introducing unemployment and underproduction, as observed in the former Soviet economies, will lead to the same conclusion.

The mathematics of the curves are presented in the reduced-form equations of the appendix. The AA curve is steeper than the GG curve due to the effect of price increases on real tax revenues. I maintain the assumption for the diagrammatic representtion that -(S,/S) > (YIO), ensuring that both curves are positively sloped.

The appendix also provides a numerical example that illustrates the steady-state equilibrium and the associated saddlepath.
Suouuined **Inailon *** 10 The economy exhibits saddlepoint stability in these two variables. Inflation leads to dissaving, budget deficits and still further inflation: this behavior has a convergent dynamic only along the saddlepath SS. Appendix A provides a mathematical derivation of the saddlepoint properties of this steady state for a linearized version of this model.

In the Soviet economy prior to price liberalization the households were not on their preferred trajectory. The constraints on both price levels and supply of goods led to rationing and fbrced saving. This forced saving resulted in the "ruble overhang" that could more properly in this context be characterized as an "asset overhang* and illustrated at point A.

# Dynamic Adjustment with Price Liberalization.

The dynamic followed from A with price liberalization replicates a number of features of private adjustment in the former Soviet republics. First, households had accumulated excess financial assets, as indicated by the position of A above the AA curve. Second, the accumulated wealth was more than necessary to cause unfinanceable budget deficits as households were unwilling to save: this is evident in A's distance above GG. Third, households nevertheless held these assets because of their claims on future consumption: this is evident in the distance by which A is below SS. When prices were liberalized there was an immediate jump, followed by ongoing inflation. The nominal value of wealth declined during the adjustment as consumers purchased real goods for consumption, while with inflation the real value of wealth (D/P) fell still more. -The government maintained budget deficits throughout, and ex ante private saving was insufficient to finance these: the inflation tax on nominal assets represents the balance of the budget.

The jump in prices was widely forecast as the means of removing the excess purchasing power represented by the ruble overhang. As the present scenario indicates, the overhang caused ongoing inflation as well: households tempered the upward pressure placed on demand for goods because of the effect of the ensuing price increases on purchasing power in the future. The price
Susained **Lnftion** - 11 jump is represented by the movement from A to B on the saddlepath; the ongoing inflation by the movement along SS from B toward E.

The historical record on saving is complicated by the collapse of production output beginning in 1991. This can be introduced as an exogenous reduction in private income (A(Y/P)<O) that reduced both private income and the tax revenue base. These place upward pressure on P; in Figure 2 the effect is illustrated as both AA and OG shift to the right. Each such shock causes an immediate burst of inflation followed by continuing price movements until the new steady state is achieved. One such path is drawn in Figure 2: beginning from equilibrium E, prices jump immediateiy to B' along the new saddlepath SS', and then decline somewhat as households accumulate assets. The new steady state at E' has a larger nominal stock of assets but a reduced real value. This period would be characterized by excess supply af goods, as prices have overshot the long-run value. Alternatively, - the increased fiscal deficit could be recognized while still on- the original saddlepath around B if so, there would be an additional jump in P followed by still fiurther inflation while moving down the other arm of SS' to E'.

Tnese properties can be demonstrated in a simple numerical example. The appendix presents the parameterization employed to generate the phase dynamics of Figure 3. The steady-state equilibrium is characterized by constant price index (P = 1) and real wealth (0' =300). Consider the evolution of an economy beginning with wealth D. = 350 and artificially suppressed price P. = .1. The initial response upon liberalization of prices is a jump to the saddlepath at P, = .61: a 510 percent increase. Subsequent to that the adjustment occurs along the saddlepath, with P rising and 0 falling toward steady-state equilibrium. The accumulated price increase over the entire adjustment path is 900 percent, with 390 percent of the price increase occurring during the gradual adjustment along the saddlepath. Real wealth in the private sector declines by 92 percent; 84 percent of the
**Suslaid Inflatn** - 12

decline takes place in the initial jump of prices following liberalizadon, while another 8 percent occurs along the saddlepath.

# III. Conclusions and extensions.

Sustained inflation can be the outcome of price liberalization if the economy begins from a situation of "ruble ovcrh-g'<sup>t</sup> . This accumulated wealth causes low levels of annual saving by the private sector. Price libera:ization will lead to a jump in prices, but this jump does not eliminate the ruble overhang. Instead, the jump places the private-sector in position to implement a flow dis-saving that ends with convergence to the steady-state outcome. That dis-saving dynamic coincides with a sustained inflationary episode.

The uynamic of adjustment is due to saddlepath stability of the economic model. This characterization depends upon the non-financed budget deficit being more responsive to price increases than private wealth accumulation. The non-buoyancy of tax revenues in response to price increases is a realistic feature of the transition economies that provides that feature, but other economic characteristics will cause this relation as well. An increase in real expenditures in response to price rises, due for example to the safety net of social expenditures being spread over newly destitute citizenS, will also have this effect)<sup>2</sup> Stability is not assured for all values of the exogenous variables. One feature in particular stands out: sufficiently high nominal interest rates can for low interest-rate elasticity of saving lead in this model to an instability of equilibrium. In that instance, the types of shocks experienced in the

**12** The sufficient mathematical condition for saddlepath stability of the steady state in this case is that -s < 6(g-t)yaP

In the specification used here, private saving (defined net of interest receipts) is zero. Thus, any featue of the budget deficit that makes it susceptible to widening in response to price increases wiNl ensure this result.
**SulI=d IaGdou** - I

ransitknaW economies lead to accleratig inflation rather than convergence to the steady staie. This s due to the budgetary cost of interest payments, and underscores the warning found in Giovannini nd deMelo (1993): financial liberalization policies must- be made Wang into consideration their budgetary impact. The possibility of instability as described here is an additional danger not onsidered in their work.