Macroeconomic Model of Transition Economy: A Stochastic Calculus Approach

Abstract

An integrated stochastic macroeconomic model of transition economy at the early stage of reforms with optimising representative risk averse agents is constructed. The equilibrium growth rate of the economy, real asset returns, domestic money demand, and expected inflation rate are determined as functions of the exogenous risks in the economy. The main issue addressed are: domestic money demand, currency substitution ratio, expected rate of inflation, real asset returns, the equilibrium growth rate of the economy as well as government ability to control these variables. Analysis of the model finds that the equilibrium growth rate of the economy is not independent on the monetary and fiscal policies but can be affected by the government through its ability to fix the real cost of capital for the firm, expenditure and monetary policy parameters.