Inflation and stabilization in transition economies: An analytical interpretation of the evidence

Abstract

A simple model is developed to understand inflationary pressures and stabilization in non-market economies. It is shown that in the typical planned economy, the endogeneity of the money supply and the over-determination of the system (given that both prices and wages are set by the planners) imply that a permanent increase in wages leads to an ever-increasing monetary overhang. The model also suggests that price liberalization should lead to a price level overshooting provided that wages remain a nominal anchor. In light of the model, the paper reviews the inflation and stabilization experiences of several transition economies in Eastern Europe and the former Soviet Union. The paper concludes that (i) transition economies have suffered from essentially the same inflationary pressures as did planned economies, and (ii) the exchange rate has been more effective than money as a nominal anchor in reducing inflation