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8 - Exchange Rate and Prices in a Stabilization Program: The Case of Croatia

Published online by Cambridge University Press:  09 October 2009

Mario I. Blejer
Affiliation:
International Monetary Fund Institute, Washington DC
Marko Skreb
Affiliation:
National Bank of Croatia
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Summary

INTRODUCTION

Croatia has achieved remarkable results in stopping high inflation and maintaining price stability. After the average monthly rate of inflation for January–October 1993 had reached almost 28%, November inflation was negligible and deflation occurred during 1994. Price stability was achieved without direct price controls, mainly by using the exchange rate: both nominal and real exchange rate appreciated immediately after announcement of the program. Real money supply has recorded significant rates of growth since November 1993, and real output showed signs of the recovery during 1994. The aim of this essay is to explain the link between the exchange rate and prices during this particular stabilization episode.

Standard explanations of exchange-rate and price dynamics assume integrated financial markets that ensure arbitrage conditions, as well as a stable money demand function (see e.g. Dornbusch 1976). Neither of these assumptions seems plausible for a country like Croatia. Money and capital markets are underdeveloped, regional risk contributes to imperfect capital mobility, and real money declined during high inflation (mostly as a result of currency substitution). In order to analyze the interplay between the exchange rates and prices we use an aggregate-demand–aggregate-supply model with the exchange rate as a cost–push factor.

In the first section we describe some basic facts about the Croatian economy, and explain the first obstacle to the direct transmission of exchange-rate fluctuations into aggregate prices: an increase in the relative price of nontradables.

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Publisher: Cambridge University Press
Print publication year: 1997

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