Nontradables Inflation and Macroeconomic Policy Mix: A Model with Policy Application to Transition Economies

Abstract

How a price increase in the nontradables sector of a transition economy affects the exchange rate, relative prices, wages, and, indirectly, the movement of factors of production. Polackova analyzes the macroeconomic effects of inflation in the nontradables sector of a small open economy to suggest how different macroeconomic policies would facilitate structural adjustment after price liberalization in a transition economy. She uses a Mundell-Fleming rational expectations model of a two-sector economy to study how inflation in the nontradables sector affects the exchange rate, relative prices, wages, and, indirectly, the movement of factors of production. She applies the analysis to a cut in producer subsidies in the nontradables sector and assesses how macroeconomic policies involving the management of supply and demand might affect government objectives for the economy and redistribution. She concludes that to alleviate the transitory negative effects of a cut in producer subsidies, targeted household transfers combined with a tax cut, if possible, are superior to expansionary monetary and fiscal policies. Making the tax cut less than the cut in subsidies and financing targeted lump-sum household transfers from government savings reduce the risk of poverty and external imbalances. The potential benefits from exchange rate management depend greatly on the level of wage discipline. This paper - a product of the Country Operations Division, Europe and Central Asia, Country Department II - is part of a larger effort in the department to support countries in continuing and sustaining social and economic growth.