The Bulgarian Economy on Its Way

to the EMU: Economic Policy Results

from a Small-scale Dynamic Stochastic
General Equilibrium Framework
Jochen Blessing
DP/60/2007
The Bulgarian Economy on Its Way
to the EMU: Economic Policy Results
from a Small-scale Dynamic Stochastic
General Equilibrium Framework
Jochen Blessing
June 2007
BULGARIAN
NATIONAL
BANK
DISCUSSION PAPERS
DISCUSSION PAPERS
DP/60/2007
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DISCUSSION PAPERS
Editorial Board:
Chairman: Statty Stattev
Members:
Tsvetan Manchev
Nikolay Nenovsky
Mariella Nenova
Pavlina Anachkova
Secretary: Lyudmila Dimova
Jochen Blessing, 2007
Bulgarian National Bank, series, 2007
ISBN: 978-954-8579-07-0
Printed in BNB Printing Center.
Views expressed in materials are those of the authors and do not necessarily reflect BNB policy.
Elements of the 1999 banknote with a nominal value of 50 levs are used in cover design.
Send your comments and opinions to:
Publications Division
Bulgarian National Bank
1. Alexander Battenberg Square
1000 Sofia. Bulgaria
Tel.: (+359 2) 9145 1351, 9145 1978, 981 1391
Fax: (+359 2) 980 2425
e-mail: Dimova.L@bnbank.org
Website: www.bnb.bg
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Contents
1 Introduction........................................................................... 5
2 A New Open Economy Macroeconomics Framework.. 5
3 The Model: Building Blocks ............................................... 6
3.1 Households ......................................................................... 6
3.2 Firms in the Non-traded and Traded Goods Sector .. 10
3.3 Hybrid Inflation dynamics .............................................. 13
3.4 Central Bank ..................................................................... 13
3.5 Government ...................................................................... 15
3.6 Foreign Sector .................................................................. 15
4 The Steady State................................................................. 19
4.1 Pricing Decision of Firms and Steady State
Price Levels ....................................................................... 19
4.2 The Real Sector ................................................................ 20
4.3 Current Account and Balance of Payments ............... 21
5 Calibration ........................................................................... 22
6 Economic Policy Analyses ................................................ 23
6.1 The Balassa-Samuelson Effect under
the Currency Board ....................................................... 23
6.2 Real Convergence and the Real Exchange Rate
in the Long-Run................................................................ 25
6.3 Fiscal Policies and the Trade Balance .......................... 25
7 Conclusions ......................................................................... 27
Technical Appendices ............................................................... 28
A Calibration........................................................................... 28
B Exogenous stochastic processes ..................................... 29
C The log-linearised model .................................................. 29
References ................................................................................... 32
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SUMMARY*. The paper develops a small-scale dynamic stochastic general equilibrium model (DSGE)
of the Bulgarian economy along the lines of the New Open Economy Macroeconomics. Our small
open economy produces traded and non-traded goods and both sectors face hybrid inflation dynam-
ics and capital adjustment costs. We incorporate the currency board mechanism and cover the bal-
ance of payments explicitly. The law of one price holds in the tradable sector implying that under flex-
ible output prices, the terms of trade adjust in a way such that the external relative price of tradables
remains constant.
Policy simulations are used to investigate the impact of changes in the economic environment to
which transition economies and Bulgaria in particular are currently exposed to. We explore the effects
of a Balassa-Samuelson (BS) type shock for sectoral and overall inflation and discuss current account
sustainability and implications for the internal real exchange rate. We find that under the currency
board the BS effect is not as persistent as found for accession countries under a fixed exchange rate in
related research. Inflationary pressures arising from real-catch up processes seem therefore not to pre-
vent compliance with the Maastricht inflation criterion.
We further analyse the impact of lump-sum government expenditures on the trade balance and the
current account. Fiscal policies under the currency board put upward pressures on the sector-specific
inflation rates and tend to yield short-run trade balance surpluses. However, intertemporal wealth ef-
fects dominate causing overall current account deficits and losses in foreign reserves. The model is
solved using Uhligs toolkit.
*
This paper was written during a research stay at the Bulgarian National Bank in July and August
2006. The author would like to thank the BNB for the financial grant as well as all members of the Eco-
nomic Research and Projection Directorate for their invaluable support. Jochen Blessing, Department
of Economics, Freie Universitat Berlin, e-mail: jochen.blessing@web.de
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1 IntroductIon
1lo polilical inlogialion of Lulgaiia inlo llo Luiopoan Union is scloouloo foi Januaiy 2007
ano llo ioao lo aoopling llo Luio is on llo loiizon. 1lo iosliucluiing of llo Lulgaiian
oconomy fiom plannoo lo maikol-Lasoo is slill incomplolo Lul ioconl oconomic oovolopmonls
aio piomising. Lulgaiia las faioo faiily woll sinco inslallmonl of llo cuiioncy Loaio in 1007
wlicl las lolpoo lo allain low inlalion ano maciooconomic slaLilily. Inlalion las ooclinoo
fiom ovoi 1000 poiconl lo loss llan poiconl looay ano ioal oconomic giowll las Loon ioLusl
sinco llon ianging Lolwoon 4 lo 6 poiconl.
1
Iiuoonl lscal ano ooLl managomonl policios in
ioconl limos onsuio llal llo Lalanco of paymonls is suslainaLlo in llo fuluio ano Liing oown
oxloinal ooLl.
Wloioas maciooconomic managomonl is woll on liack in Lulgaiia lloio is an oflon voicoo
concoin foi Luio-accossion counliios unooi lxoo oi loavily managoo oxclango ialos llal inla-
lionaiy supply-sioo piossuios migll piovonl soon complianco will llo inlalion ciiloiion ano
oolay LIM II onliy. Unooi llo aulomalic cuiioncy Loaio llo cloico of slaLilisalion policios
is limiloo lo llo lscal slanco ano conliaclionaiy policios migll Lo nooooo in oiooi lo copo
will lloso piossuios. On llo olloi lano, llo ongoing iosliucluiing of llo Lulgaiian oconomy
lowaios a maikol-Lasoo oconomy will slill nooo oxpansionaiy lscal policios oiiocloo lowaios
infiasliucluio invoslmonls ano llo liko llal pul oomano-sioo piossuios on llo inlalion ialo.
1lo fiamowoik pioposoo loio illuslialos lloso upwaio piossuios on oomoslic consumoi piico
inlalion (cpi) Ly Loll supply ano oomano sioo plonomona willin llo fiamowoik of llo Now
Opon Lconomy Maciooconomics. Oui small opon oconomy piooucos liaooo ano non-liaooo
gooos ano foaluios socloi spocilc lyLiio inlalion oynamics as woll as capilal aojuslmonl cosls.
In pailiculai, wo incoipoialo llo cuiioncy Loaio moclanism ano covoi llo Lalanco of paymonls
oxplicilly. Wo also invosligalo llo oconomic consoquoncos foi llo ioal oxclango ialo wlolloi
govoinmonl sponoing falls on lomo-liaoaLlos oi lomo soivicos. Foi llo oaso of oxposilion llo
law of ono piico lolos in llo liaoaLlos gooos pioouclion, in olloi woios llo foioign (LMU)
lims cannol piico-oisciiminalo acioss llo Loiooi. 1lis assumplion is loioic givon llo lalosl
oslimalions of oxclango ialo pass-lliougl in Lulgaiia (soo Dimiliova (2006), foillcoming). 1lo
oxclango ialo pass-lliougl lo ovoiall inlalion is founo lo Lo aiouno 0.8 ano llo socono slago
of llo pass-lliougl olocl oolnoo as llo olaslicily of oomoslic piicos lo inloinalional piicos is
0.27. 1lo assumplion of full pass-lliougl fiom foioign liaoaLlos inlalion lo llo oomoslic ono
can slill Lo jusliloo Ly llo iolo of oui moool soiving as a Lonclmaik fiamowoik.
Wo piocooo as follows. Soclion 2 oiscussos llo iolaloo liloialuio ano 8 sols oul llo maciooco-
nomic fiamowoik along llo linos of llo Now Opon Lconomy Maciooconomics (NOLM). Soclion
4 analysos llo long-iun oquiliLiium of llo oconomy ano soclion oosciiLos llo caliLialion lo
llo Lulgaiian oala. Unooi 6 wo piovioo iosponsos of oconomic koy vaiiaLlos following slocks
in pioouclivily ano lscal sponoing. Conclusions follow.
2 A ev Oen Econony AacroecononIcs Iranevork
Unooi llo aulomalic cuiioncy Loaio moclanism, llo oomoslic Laso monoy is fully Lackoo Ly llo
slock of foioign iosoivo loloings wlicl iomovos any oisciolionaiy monolaiy policy powoi fiom
llo conlial Lank. 1lo moclanism oslaLlislos a oiiocl link Lolwoon llo Lalanco of paymonls
ovolvomonls ano llo oomoslic monoy supply. A Lalanco of paymonls oolcil causos aulomalic
conliaclion in iosoivo monoy ano lloiofoio conliacls oomoslic ciooil ano vico voisa. Mooolling
llo cuiioncy Loaio moclanism in gonoial oquiliLiium moools las so fai nol founo wioospioao
allonlion ano moools aoaploo lo llo Lulgaiian caso aio iaioly availaLlo. A gonoial oquiliLiium
moool of llo liaoo Lalanco oynamics in Lulgaiia is oovolopoo in Valov (200) willin a nooclas-
sical giowll moool ano lonco aLsliacling fiom nominal iigioilios. DosquilLol ano Nonovsky
1
Soo Soisa (2002) foi an ovoiviow of ioconl oconomic oovolopmonls in Lulgaiia.
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(2008) oiscuss llo slaLilily of llo cuiioncy Loaio in llo conoilions of solf-fulllling oxclango
ialo ciisis willin a monoy in ulilily fiamowoik. 1lo lalloi moool ooos nol foaluio oiloionl
pioouclion soclois ano llo aullois acknowloogo llal inclusion of llo lalloi woulo soiiously
alocl inlalion ano ioal oxclango ialo oynamics.
Wo consliucl a moool wlicl is iicloi in sliucluio llan llo aLovo monlionoo moools ano wo
follow llo NOLM liloialuio in mollooology. 1lo NOLM compiisos maciooconomic fiamowoiks
will oxplicil miciofounoalions llal incoipoialo somo soil of piico anooi wago iigioily wlicl
causos piicos ano monolaiy oovolopmonls lo inluonco llo ioal oconomic onviionmonl. 1lo
Lasic sliucluio of llo moool is clososl lo Nalalucci ano Iavonna (2008). Honiiksson (200),
Lonigno ano 1loonisson (2008), as woll as Lokil (200) aio olloi main inluoncos. Wloioas
Nalalucci ano Iavonna (2008) only allow foi foiwaio-looking inlalion oynamics wo also allow
foi Lackwaio looking piico solling wlicl allogolloi gonoialos lyLiio, oi 'lumpoo-slapoo'
impulso-iosponsos of inlalion. HyLiio inlalionaiy poifoimanco can Lo llougll of as a pioxy
of llo slow iosliucluiing of lims willin llo Lulgaiian oconomy. Oui moool lakos inlo accounl
llal foi a sum cionl sluoying of Lusinoss cyclo oynamics in liansilion oconomios, invoslmonl ano
capilal lavo lo Lo incoipoialoo in llo moool.
Wo inlogialo llo cuiioncy Loaio moclanism ano moool llo Lalanco of paymonls oxplicilly.
Wo lloiofoio oLlain a oiiocl link Lolwoon llo slock of foioign iosoivos loloings ano oomoslic
Laso monoy supply. 1o liglligll llo claiacloi of llis conliiLulion as a lisl slop of mooolling
llo cuiioncy Loaio willin llo NOLM wo iofiain fiom any foaluios llal Lioak llo aulomalion in
llo cuiioncy Loaio moclanism. Oui conlial Lank las no possiLilily of inluoncing llo oomoslic
Laso monoy Ly any moans. 1loio is no monolisalion of govoinmonl ooLl, as llo lscal slanco
las lo Lo in Lalanco ovoiy poiioo.
Lulgaiia`s cuiioncy Loaio aclually foaluios non-aulomalic olomonls llal cul llo oiiocl link
Lolwoon llo Lalanco of paymonls ano oomoslic monoy supply (soo Milloi (1000) foi llo ompiii-
cal ovioonco). Namoly, lloio oxisls llo ioquiiomonl of commoicial Lanks lo mainlain iosoivos in
llo conlial Lank. Fuilloi, Nonovsky ano Hiislov (2002) aiguo llal llo inclusion of govoinmonl
lscal iosoivos in llo liaLilily sioo of a cuiioncy Loaio (i.o. covoiing llom will inloinalional
iosoivos) cioalos a oisciolionaiy clannol of monolaiy policy liansmission in Lulgaiia. Govoin-
monl iovonuo ano oxponoiluio policios lloiofoio oiioclly impacl llo iosoivo monoy ano, lonco,
llo monoy supply. 1lo moool oovolopoo so fai can lloiofoio soivo as llo Lonclmaik fiamo-
woik againsl wlicl lo juogo oulcomos of oisciolionaiy monolaiy policy possiLililios unooi llo
Lulgaiian cuiioncy Loaio.
3 TLe nodeI: LuIIdIng LIocks
3.1 HouseLoIds
3.1.1 IreIerences and DecIsIon IroLIen
1lo small opon oconomy is inlaLiloo Ly a conlinuum of lousololos llal iosioo on llo inloival
[0, 1[. In any poiioo, a lousololo , iocoivos ulilily fiom consuming llo consumplion inoox C
)
:
wlicl is a composilo of non-liaooo gooos consumplion C
`,)
:
ano liaoaLlo gooos consumplion
C
T,)
:
. C
T,)
:
consisls of lomo piooucoo liaoaLlo gooos consumplion C
)
1,t
ano foioign piooucoo
liaoaLlo gooos consumplion C
)
1,t
. 1lo lousololo ooiivos ulilily fiom liquioily soivicos pioviooo
Ly loloing ioal monoy Lalancos
1

s
1:
. Ulilily fiom loloing monoy Lalancos is nol covoioo Ly Lono
loloings wlicl piovioo inoiiocl ulilily lliougl llo incomo lloy gonoialo. 1lo lousololo las
oisulilily \ (1
)
:
) Ly giving up loisuio foi supplying laLoui lo lims in llo liaoaLlo socloi T
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ano non-liaoaLlo socloi . Lacl lousololo maximisos llo following lifo-limo ulilily funclion
l
)
t
= 1
t

:t
,
:t
[l(C
)
:
) (
'
)
:
1
:
) \ (1
)
:
)[ (1)
wlicl is aooilivoly sopaiaLlo in llo poi-poiioo funclions l, , ano \ .
2
Wo assumo llo following
funclional foims wlicl aio concavo in lloii aigumonls as in Nalalucci ano Iavonna (2008) ano
Lokil (200)
l(C
)
:
) = lnC
)
:
(2)
(
'
)
:
1
:
) = ln
'
:
1
:
(8)
\ (1
)
:
) = 0
(1
S,)
:
)
i
i
(4)
(2) implios llal llo agonl is iisk-avoiso ano llal llo inloilompoial olaslicily of suLslilulion ano
llo inlialompoial iolalivo iisk avoision coincioo ano aio oqual lo unily. oonolos llo ulilily
scalo paiamoloi foi ioal monoy Lalancos
1

s
1
s
ano 0 is llo iospoclivo paiamoloi foi lolal laLoui
supply of lousololo ,, 1
S,)
:
. i 1 oonols laLoui supply olaslicily.
LaLoui supply of lousololo , is moLilo willin llo counliy ano lonco acioss llo soclois ano
poifoclly suLslilulaLlo Lolwoon H ano
1
S,)
:
= 1
)
`,:
1
)
1,:
()
1
)
`,:
oonolo louis woikoo in llo socloi ano 1
)
1,:
oonolo louis woikoo in llo H socloi. Wo
assumo llal llo inlialompoial olaslicily of suLslilulion Lolwoon liaooo gooos T ano non-liaooo
gooos is oqual lo ono. Wo llon oLlain llal piofoioncos aLoul lolal consumplion aio of llo
CoLL-Douglas foim
C
)
:
=
(C
)
T,:
)

(C
)
`,:
)

(1 )

(6)
1iaoaLlo consumplion C
)
T,:
is oiviooo Lolwoon lomo piooucoo gooos H ano foioign liaoaLlo
gooos 1
C
)
T,:
=
(C
)
1,:
)
i
(C
)
1,:
)

i
i
(1 i)
i
(7)
wloio again llo inlialompoial olaslicily of suLslilulion Lolwoon lomo piooucoo H ano foioign
piooucoo liaoaLlos 1 oquals ono. 1lo lalloi onsuios llal llo Law of Ono Iiico (LOI) will
lolo in llo liaoaLlo socloi. 1lo non-liaoaLlo consumplion Laskol is oolnoo as llo aggiogalo
consumplion ovoi all non-liaoaLlos piooucoo al lomo
C
)
`,:
= [
_

(c
)
`,:
(.))
p
p
d.[
p
p
(8)
1lo consumplion Lasoo piico inoox (CII) 1
:
iosulls fiom minimising lolal oxponoiluios of
lousololo , foi oLlaining 1 unil of llo consumplion inoox C
)
:
ovoi llo aigumonls C
)
`,:
ano C
)
T,:
1
:
= (1
T,:
)

(1
`,:
)

(0)
2
Aooilivo sopaiaLilily onsuios llal oacl maiginal ulililyoisulilily in ono of llo aigumonls ooos nol oopono
on llo iospoclivo olloi aigumonls.
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Ly llo samo piocoouio wo oLlain llo liaoaLlos piico inoox
1
T,:
= (1
1,:
)

(1
1,:
)

(10)
ano analogously
1
`,:
= [
_

(j
`,:
(.))
,
^
d.[

p
^
(11)
3.1.2 OtInaIIty condItIons
1lo Luogol consliainl foi lousololo , in nominal loims ioaos
1
)
1,t
o
t
1
)
1,t
Q
)
t
'
)
t

_

H
)
`,t
(.)d.
_

H
)
1,t
(.)d. \
)
1,t
1
)
1,t
\
)
`,t
1
)
`,t
(12)
1
`,t
1
`,)
t
1
`,)
t
1
1,t
1
1,)
t
1
1,)
t
1
t
C
)
t
T
t
'
)
t
1
1,1
t
1
1,)
t
1
1,`
t
1
`,)
t

1
)
1,t
1 i
t

o
t
1
)
1,t
1 i

t
1lo lousololo iocoivos incomo fiom inloiosl paymonls on lomo zoio coupon Lonos 1
)
1,t
ano foioign zoio coupon Lonos o
t
1
)
1,t
, lump-sum liansfois fiom llo govoinmonl Q
)
t
, fiom
monoy loloings '
)
t
ano piolls of lims. Slo iocoivos facloi incomo fiom supplying laLoui
lo lims in llo H ano socloi \
)
1,t
1
)
1,t
\
)
`,t
1
)
`,t
ano ionling oul capilal 1
`,t
1
`,)
t
1
`,)
t

1
1,t
1
1,)
t
1
1,)
t
. 1lo iovonuos aio usoo lo lnanco lolal consumplion ano invoslmonl oxponoiluios
1
t
C
)
t
1
1,1
t
1
1,)
t
1
1,`
t
1
`,)
t
, pay lump-sum laxos T
t
, caiiy monoy lo llo noxl poiioo '
)
t
, ano
puiclaso oomoslic ano foioign Lonos. As llo piivalo socloi issuos llo Lonos wo can llink of
1
)
1,:
ano 1
)
1,:
as coipoialo Lonos issuoo Ly llo lousololo-ownoo lims. Nolo llal if 1
)
1,:
< 0,
lousololo , is a nol ooLloiissuoi of llo lomo Lono. As llo govoinmonl ooos nol lavo an
oLjoclivo funclion ano llo Lalanco is pail of llo lousololos Lalanco, wo can inloipiol llo lomo
coipoialo Lono similaily as a Lono issuoo Ly llo govoinmonl. As llo inloilompoial ulilily
funclion l
)
t
givon Ly (1) las llo usual piopoily of local non-salialion as il is concavo in ils
aigumonls ano aooilivoly sopaiaLlo in poi poiioo ulililios, om cioncy ioquiios llal llo Luogol
consliainl (12) will lolo will oqualily.
i

t
oonolos llo nominal woilo inloiosl ialo al wlicl oomoslic agonls can Luysoll foioign
assols. i

t
is compiisoo of llo woilo inloiosl ialo plus a iisk piomium incioasing in nol ioal
foioign liaLililios lo Lo inliooucoo Lolow. i
t
is llo oomoslic nominal sloil ialo. Homo louso-
lolos possoss llo H ano lims ano oocioo on invoslmonl sponoing ano capilal aojuslmonl.
Housololo , lloiofoio las lo lako inlo accounl llo law of accumulalion of capilal in llo H ano
soclois wlon oocioing on llo oplimum capilal slock 1
J
t
ano poiioo invoslmonl 1
J
t
, J = H, .
Capilal accumulalion lloiofoio follows
1
`
t
= 1(
1
`
t
1
`
t
)1
`
t
(1 c)1
`
t
(18)
1
1
t
= 1(
1
1
t
1
1
t
)1
1
t
(1 c)1
1
t
(14)
Capilal accumulalion incuis concavo aojuslmonl cosls 1

0 1

.
Wo ono up will llo following oplimalily conoilions. Consumplion Lolwoon liaooo ano
non-liaooo gooos is givon Ly
C
T,:
C
`,:
=

1
1
`,:
1
T,:
(1)
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ano analogously foi llo cloico Lolwoon lomo piooucoo ano foioign piooucoo liaoaLlos Laskol
C
1,:
C
1,:
=

1
o
t
1

1,:
1
1,:
=

1
o
t
1
1,:
(16)
wloio o
t
oonolos llo nominal oxclango ialo (assumoo lo Lo lx). As llo oconomy is small il
cannol alocl woilo piicos ano lakos llo foioign piico lovol 1

1,:
as givon. Wo noimalisoo llo
lalloi lo 1.
8
1lo inloilompoial consumplionsavings oocision is guiooo Ly llo Luloi oqualion
`
C
t
= ,1
t
[`
C
t
(1 i
t
)
1
t
1
t
[ (17)
wloio `
C
t
= (C
)
t
)

is llo maiginal ulilily of lolal consumplion. Honco

1
C
)
t
= ,1
t
[
1
C
)
t
(1 i
t
)
1
t
1
t
[ (18)
1lo assumoo foim foi ulilily oul of lolal consumplion implios llal ulilily fiom consumplion is
aooilivoly sopaiaLlo in H, , 1 consumplion. Wo llon oLlain llal llo Luloi oqualions foi llo
non-liaoaLlo ano lomo-piooucoo liaoaLlos consumplion aio
1
C
)
`,t
= ,1
t
[
1
C
)
`,t
1
`
t
1
`
t
(1 i
t
)[ (10)
1
C
)
1,t
= ,1
t
[
1
C
)
1,t
1
1
t
1
1
t
(1 i
t
)[ (20)
Fuilloi, llo lousololo oocioos on loi lolal supply of laLoui accoioing lo
0(1
)
1,t
1
)
`,t
)
i
C
)
t
=
\
t
1
t
(21)
wlicl says llal llo lousololo piovioos laLoui up lo llo poinl wloio llo maiginal ialo of
suLslilulion Lolwoon consumplion ano loisuio oquals llo ioal wago in loims of lolal consumplion
unils. Wo lavo usoo llo facl llal ouo lo moLilily of laLoui Lolwoon llo soclois ano llo poifocl
suLslilulaLilily of piovioing laLoui in llo liaooo voisus non-liaooo socloi, nominal wagos lavo
lo Lo llo samo in Loll soclois \
1
t
= \
`
t
= \
t
. 1lo liaoo-ol Lolwoon ioal monoy Lalancos
ano lolal consumplion is ooloiminoo Ly
(
'
)
t
1
t
)

= `
C
t
,1
t
[`
C
t
1
t
1
t
[
Ly using llo Luloi oqualion (17) wo oLlain llo monoy oomano oqualion

(
1

I
1
I
)

`
C
t
=
i
t
1 i
t
(22)
wlicl slalos llal llo maiginal ialo of suLslilulion Lolwoon ioal monoy Lalancos foi consump-
lion oquals llo oiscounloo payol on Lono oainings wlicl acciuo in poiioo t 1. Iayols aio
oiscounloo Ly using llo sloclaslic oiscounl facloi ooiivoo fiom (18).
In oiooi lo oLlain an om cionl invoslmonl ano plysical capilal allocalion, llo lousololo
maximisos ulilily will iospocl lo llo consliainls (18) ano (14) as woll as llo ioal lousololo
8
Wo coulo alloinalivoly assumo llal llo foioign piico lovol follows a slaLlo oxogonous sloclaslic piocoss.
10
D
P
/
6
0
/
2
0
0
7
Lalanco. Invoslmonl in llo non-liaooo socloi sloulo lloiofoio Lo guiooo Ly
`
C
t
1
1,`
t
1
t
Q
`
t
= ,1
t
[`
C
:
1
`,:
1
:
1
`
:
[ (28)
,1
t
[`
C
t
1
1,`
t
1
t
Q
`
t
[[1[
1
`
t
1
`
t
[ 1

[
1
`
t
1
`
t
[
1
`
t
1
`
t
(1 c)
wloio wo lavo aggiogaloo ovoi all lousololos. Q
`
t
oonolos 1oLin` s Q in llo non-liaooo socloi
oolnoo as llo maikol valuo of capilal ovoi ils ioplacomonl cosl. Analogously wo oLlain foi llo
H socloi
`
C
t
1
1,1
t
1
t
Q
1
t
= ,1
t
[`
C
:
1
1,:
1
:
1
1
:
[ (24)
,1
t
[`
C
t
1
1,1
t
1
t
Q
1
t
[[1[
1
1
t
1
1
t
[ 1

[
1
1
t
1
1
t
[
1
1
t
1
1
t
(1 c)
Capilal compaioo lo laLoui is immoLilo Lolwoon llo soclois willin llo counliy, i.o. ox-posl
ionlal ialos of oquipmonl in llo H ano givon Ly 1
`,:
ano 1
1,:
can oiloi. Honco lloio is no
ox-posl ionlal piico oqualisalion. In long-iun oquiliLiium lowovoi, ionlal piicos will oqualiso as
is slown in soclion 4.
3.1.3 IrIvate Sector HaIance
1lo Luogol consliainl foi lousololo , in nominal loims is givon Ly (12). Aggiogaling ovoi all
lomo agonls , [0, 1[ al lomo wo oLlain llo piivalo socloi Lalanco:
1
1,t
o
t
1
1,t
Q
t
'
t
H
`,t
H
1,t
\
1,t
1
1,t
\
`,t
1
`,t
1
1,t
1
1
t
1
1
t
1
`,t
1
`
t
1
`
t
= 1
T,t
C
T,t
1
`,t
C
`,t
T
t
'
t
1
1,1
t
1
1
t
1
1,`
t
1
`
t

1
1,t
1 i
t

o
t
1
1,t
1 i

t
(2)
Wo lavo usoo llo facl llal all lousololos mako samo oplimum oocisions as llo iopiosonla-
livoavoiago lousololo, as lloy faco llo samo sol of consliainls ano piofoioncos (olaslicilios).
Honco C
)
T,t
= C
T,t
ano
_

C
)
T,t
d, =
_

C
T,t
d, = C
T,t
, ano so on foi llo olloi vaiiaLlos. Nolo
llal only in llo closoo oconomy wo woulo lavo llal
_

1
)
1,:
d, = 0, as llo oomoslic assol maikol
woulo lavo lo cloai in llo oomoslic oconomy ano lloio woulo Lo no possiLilily of loloing lomo
Lonos aLioao. Hoio wo lavo llal 1
1,:
1

1,:
= 0 oi 1
1,:
= 1

1,:
, wloio 1

1,:
oonolo lomo
Lonos lolo al foioign.
3.2 FIrns In tLe non-traded and traded goods sector
3.2.1 DonestIc IroductIon and DecIsIon IroLIen
Loll soclois aio populaloo Ly a conlinuum of monopolislically compolilivo lims iosioing in
llo inloival [0, 1[. Impoifocl suLslilulaLilily of piooucoo gooos allows foi piico-solling powoi of
lims ovoi lloii piooucl. Duo lo lloii nogligiLlo sizo lloy cannol inluonco llo ovoiall aggiogalo
piico lovol of llo iospoclivo socloi ano lako il as givon. In llo solup consiooioo loio wo assumo
llal oomoslic lims aio wlolly ownoo Ly lomo lousololos ano all piolls aio oisliiLuloo lo
oomoslic iosioonls in llo foim of oivioonos.
4
4
Wo will iolax llis assumplion in a follow up papoi foi llo liaooo-gooos socloi wlon wo inlioouco foioign
oiiocl invoslmonl (FDI) wlicl soivos as an inloimooialo gooo in liaoaLlo gooos pioouclion.
11
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
Lacl lim . [0, 1[ in llo liaoaLlo socloi comLinos capilal 1
1
:
(.) ano laLoui 1
1,:
(.)
accoioing lo llo CoLL-Douglas pioouclion funclion
j
1,:
(.) =
1
:
(.)(1
1
:
(.))
c
1
(1
:
(.))
c
1
(26)
wloio 1
1
:
(.) =
_

1
1,)
:
(.)d, ano 1
1,:
(.) =
_

1
)
1,:
(.)d,.
1
:
(.) =
1
:
is lolal facloi
pioouclivily in llo liaoaLlo socloi lo Lo llo samo foi all lims ano follows an oxogonous AI(1)
sloclaslic piocoss. Cosl minimisalion yiolos llo slanoaio facloi oomanos
\
:
1
1,:
= 'C
1
:
(1 c
1
)
j
1,:
(.)
1
1,:
(.)
(27)
1
1
:
= 'C
1
:
c
1
j
1,:
(.)
1
1,:
(.)
(28)
ano analogously in llo non-liaooo socloi
\
:
1
`,:
= 'C
`
:
(1 c
`
)
j
`,:
(.)
1
`
:
(.)
(20)
1
`
:
= 'C
`
:
c
`
j
`,:
(.)
1
1,:
(.)
(80)
wloio 'C
J
:
oonolos ioal maiginal cosl in llo iospoclivo socloi J = H, . Nolo llal in Loll
soclois, lims Laso lloii laLoui oomano on llo ioal wago oLlainoo Ly oolaling llo nominal
wago Ly llo socloi-spocilc aggiogalo piico lovols 1
1,:
ano 1
`,:
, iospoclivoly.
LaLoui supply is slooioo Ly llo consumplion Lasoo ioal wago wlicl can Lo soon fiom (21).
Finally, llo laLoui maikol cloais al all oalos
1
S
:
=
_

1
)
1,:
1
)
`,:
d, = 1
1
:
= 1
:
wloio foi llo socloi-spocilc laLoui supplios
1
)
1,:
=
_

1
)
1,:
(.)d.
1
)
`,:
=
_

1
)
`,:
(.)d.
3.2.2 CaIvo-IrIcIng In tLe H and sector
Wo go lliougl llo ioasoning foi llo liaooo socloi only. Iosulls foi llo non-liaooo gooos socloi
aio ooiivoo analogously. As a monopolislic compoliloi, oacl lim in llo liaooo gooos socloi
las lo lako inlo accounl llo oomano foi ils gooo. Il can only soll moio Ly lowoiing ils piico.
Domano foi gooo . consisls of consumplion ano invoslmonl oomano of any lousololo , givon
Ly c
)
1,:
(.), i
)
1,:
(.), , [0, 1[, govoinmonl oomano q
1,:
(.), ano foioign oomano c

1,:
(.) (oxpoils)
c
)
1,:
(.) = (
j
1,:
(.)
1
1,:
)
,
1
C
)
1,:
i
)
1,:
(.) = (
j
1,:
(.)
1
1,:
)
,
1
1
)
1,:
12
D
P
/
6
0
/
2
0
0
7
c

1,:
(.) = (
j

1,:
(.)
1

1,:
)
,

1
C

1,:
= (
j
1,:
(.),-
:
(.)
1
1,:
,o
:
)
,
1
C

1,:
q
1,:
(.) = (
j
1,:
(.)
1
1,:
)
,
1
G
:
Wo lavo usoo llal llo law of ono piico lolos foi oacl lim in llo liaoaLlo socloi j

1,:
(.) =
j
1,:
(.),-
:
(.) wlicl ioquiios llal llo piico olaslicilios of oomoslic ano foioign oomano con-
coining liaoaLlos aio oqual, j

1
= j
1
. Fuilloi -
:
(.) = o
:
i.o. llo nominal oxclango ialo is
lo Lo givon foi any lomo piooucoi ano lloiofoio in aggiogalo 1

1,:
= 1
1,:
,o
:
ano ovonlually
c

1,:
(.) = (
j
1,s
:
1
1,s
)
,
1
C

1,:
. Aggiogaling ovoi all lousololos ano noling llal lloy aio aliko con-
coining piofoioncos ano consliainls wo oLlain llo ovoiall oomoslic piivalo socloi consumplion
ano invoslmonl oomano foi gooo .
c
1,:
(.) =
_

c
)
1,:
(.)d, = (
j
1,:
(.)
1
1,:
)
,
1
C
1,:
i
1,:
(.) =
_

i
)
1,:
(.)d, = (
j
1,:
(.)
1
1,:
)
,
1
1
1,:
Fiim . sols llo piico sucl llal oulpul j
1,t
(.) mools ovoiall oomano
j
1,t
(.) = (
j
1,t
(.)
1
1,t
)
,
1
(C
1,t
C

1,t
G
1,t
1
1,t
) (81)
j
1,t
(.) = (
j
1,t
(.)
1
1,t
)
,
1
1
1,t
(82)
wloio wo lavo sol llo oalo - = t.
1lo oLjoclivo of llo lim in oacl socloi is lo maximiso llo oxpocloo oiscounloo low of fuluio
piolls. Wo assumo Calvo (1088) piicing in llo sonso llal oacl lim facos an oxogonous ano
lxoo pioLaLilily in llo liaooo socloi (1 0
1
) ano (1 0
`
) in llo non-liaooo socloi of Loing
aLlo lo iosol piicos in any poiioo. Wlon io-solling llo piico of llo piooucl il las lo lako inlo
accounl llal llo piico las lo iomain oplimal, givon llal lloio will Lo no iosolling possiLilily
lill poiioo t -. 1lo oocision pioLlom of llo liaooo socloi lim can llon Lo slaloo as follows
max
j
1,I
:
1
t

:
(0
1
)
:
^
:,t:

j
1,t
(.)
1
t:
j
1,t:
(.) 'C
1
t:
j
1,t:
(.)
s.l. j
1,t:
(.) = (
j
1,t
(.)
1
1,t:
)
,
1
1
1,t:
s.l. 1
1,t
,
1

= (1 0
1
)(j
c
1
)
,
1

0
1
1
,
1

1,t
1lo laloi conoilion slalos llal al oacl poinl in limo llo lomo-liaooo piico lovol is a woiglloo
avoiago of piicos closon Ly lims llal io-sol piicos in t ano lloso llal coulo nol. ^
:,t:
=
1
t
[,
:
(
C
Is
C
I
)

[ oonolos llo sloclaslic oiscounl facloi usoo foi ovalualing llo oxpocloo fuluio
pioll slioams Ly llo lim al oalo t. Oplimal piico solling Ly lim . llon Locomos
j
c
1,t
(.)
1
1,t
=
j
1
j
1
1
1
t

:
(0
1
,)
:
(C
t:
)

'C
1
t:
(
1
1,Is
1
1,I
)
,
1
1
1,t:
1
t

:
(0
1
,)
:
(C
t:
)

(
1
1,Is
1
1,I
)
,
1

1
1,t:
(88)
13
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
3.3 HyLrId InatIon dynanIcs
Inoilia in llo piico lovol oynamics is inliooucoo Ly assuming llal lloio is a slaio of .
1
lims in
llo H socloi ano a slaio of .
`
lims in llo socloi as woll as of .
1
lims in llo foioign counliy
wlicl aio Lackwaio looking as in Gali ano Goilloi (1000). 1loy aio Lackwaio-looking in llo
sonso llal lloy lavo lo uso lasl poiioo`s oplimally sol piicos ano llo clango in llo aggiogalo
piico lovol as infoimalional souicos wlon iosolling piicos. Foi llo H socloi llo piico sol Ly a
Lackwaio looking lim is lloiofoio
1
o
1,t
= 1

1,t
1
1,t
1
1,t
(84)
1lo aggiogalo piico lovol in llo liaoaLlo socloi llon ovolvos accoioing lo
1
1,t
=
_
(1 0
1
)1
,,
1
1,t
0
1
1
,
1
1,t
_
p
1
(8)
(1 0
1
) is llo oxogonous pioLaLilily llal a lim can io-sol piicos in t wlicl is llon splil
Lolwoon lims llal oplimiso ano lloso llal oo nol wlon solocling a now oulpul piico. Analogous
iolalionslips lolo in llo socloi ano foi liaoaLlos pioouclion al foioign. 1

1,t
is an inoox of
nowly (oplimally) sol piicos Ly foiwaio- ano Lackwaio looking lims
1

1,t
=
_
(1 .
1
)1
),,
1
1,t
.
1
1
o,,
1
1,t
_
p
1
(86)
1

1,t
conlains nowly sol piicos of all lims llal io-sol piicos in t, Lo lloy foiwaio- (oplimising)
oi Lackwaio- (non-oplimising) looking. Log-linoaiising llo aLovo llioo inoicos aiouno 1
t
yiolos
j
o
1,t
= j

1,t

1,t

1,t
j
1,t
= (1 0
1
) j

1,t
0
1
j
1,t
j

1,t
= (1 .
1
) j
)
1,t
.
1
j
o
1,t
Analogous iolalionslips lolo in llo socloi. Afloi log-linoaiisalion wo ono up will llo fol-
lowing socloi-spocilc lyLiio inlalion oynamics

1,t
= `
o
1

1,t
`
nc
1
:c
1,t
`
)
1
1
t

1,t
(87)

`,t
= `
o
`

`,t
`
nc
`
:c
`,t
`
)
`
1
t

`,t
(88)
1lo ooop paiamolois aio `
o
1,t
=
.
1
0
1
.
1
0
1
o
, `
nc
1
1,t
=
.
1
0
1
0
1
o
.
1
0
1
0
1
o0
1
, `
)
1,t
=
o0
1
.
1
`
o
1,t
ano analogously foi llo socloi. Foi llo slaio of Lackwaio looking lims .
1
, .
`
0
wo oLlain llo foiwaio-looking Now Koynosian Ilillips cuivos.

3.4 CentraI Hank

1lo conlial Lank iocoivos incomo fiom soignioiago oainings '
t
'
t
wlon issuing Laso monoy
'
t
ano inloiosl oainings on ono poiioo foioign oiscounl Lonos o
t
1
C
1,t
. 1lo monolaiy aulloiily
is nol allowoo lo puiclasosoll Lonos oonominaloo in lomo cuiioncy, in olloi woios oomoslic
ciooil las lo Lo fully covoioo Ly llo slock of foioign iosoivos. 1loiofoio, llo monolaiy Laso
'
t
as woll as llo sloil iun oomoslic inloiosl ialo i
t
aio onoogonous ano cannol Lo inluoncoo.
Iovonuos aio usoo lo puiclaso 1
C
1,t
unils of foioign puio oiscounl Lono wlicl cosl
S
I
1
C
T,I
i

I
in
lomo cuiioncy ano maluio al Loginning of poiioo t 1. 1lo conlial Lank Lalanco lloiofoio

Foi a oolailoo ooiivalion of llo lyLiio inlalion oynamics ploaso iofoi o.g. lo HolmsLoig (2006).
14
D
P
/
6
0
/
2
0
0
7
ioaos
'
t
'
t
= 7
t
7
t

o
t
1
C
1,t
1 i

t
o
t
1
C
1,t

t
(80)
1
C
1,t
oonolos llo quanlily of nominal puio oiscounl Lonos lolo Ly llo conlial Lank llal aio
issuoo al ono of t ano pay oul 1 unil of foioign cuiioncy al llo Loginning of t 1. Clangos
in foioign iosoivos loloings 7
t
7
t
aiising fiom movomonls in llo Lalanco of paymonls aio
incluooo on llo assol sioo (iigll lano sioo) of llo Lalanco.
S
I
1
C
T,I
i

I
o
t
1
C
1,t
aio nol nominal
foioign assols of llo conlial Lank.
t
0 aio nominal nol liansfois of llo conlial Lank lo llo
govoinmonl afloi Lono puiclasos ano monoy supply clangos aio accomplisloo. As
t
las no
sign iosliiclion, liansfois can go oilloi way ano so llis vaiiaLlo iosomLlos llo possiLilily llal
llo govoinmonl can ooposil iovonuos in llo conlial Lank (wlicl aio liaLililios lo llo conlial
Lank ano lavo lo Lo fully covoioo Ly foioign iosoivo loloings). Honco lloio is llooiolically a
way of lnancing of govoinmonl oolcils Ly monolisalion. As oui moool ooos nol foaluio puLlic
ooLl ano llo lscal slanco is lo Lo Lalancoo ovoiy poiioo llis clannol of oisciolionaiy monolaiy
policy is closoo. Wo soo llal ono way of lnancing foioign Lono puiclasos is Ly poiioo t lump
sum laxalion of llo govoinmonl.
Unooi llo aulomalic cuiioncy Loaio oomoslic Laso monoy '
t
al any poinl in limo is fully
Lackoo Ly foioign iosoivo loloings
7
t
'
t
wloio om cioncy ioquiios llal
7
t
= '
t
(40)
wlicl yiolos llo iosull llal al any poinl in limo llo slock of cuiioncios ano coins in ciiculalion
ovolvos accoioing lo
'
t
= '
t
7
t
7
t
(41)
(40) is llo 'policy iulo' of llo conlial Lank unooi llo cuiioncy Loaio ano closos llo moool.
6
1lo oomoslic Laso monoy supply aojusls moclanically lo Lalanco of paymonls oolcilssuiplusos
ano llo conlial Lank cannol sloiiliso llis impacl as il woulo Lo possiLlo unooi a lxoo oxclango
ialo syslom (Ly clanging lomo iosoivos in llo opposilo oiioclion).Wo fuilloi soo fiom (80) llal
llo iulo implios llal o
t
1
C
1,t
=
S
I
1
C
T,I
i

t
. Solving llo lalloi foiwaio wo oLlain
1
C
1,t
= (
T

:t
1
1 i

:
)1
C
1,:

T

:t
(
:

)t
1
1 i

)
)

:
o
:
will
t

)t

1. Iuling oul Ionzi-sclomos, i.o. imposing llo conoilion llal llo inilial conlial
Lank assols lavo lo Lo ioooomoo soonoi oi laloi ioquiios
lim
T
(
T

:t

s
)1
C
1,T
= 0
1lo inilial assol posilion is lloiofoio (ox posl
7
) suslainaLlo if
1
C
1,t
=

:t
(
:

)t
1
1 i

)
)

:
o
:
6
Unooi an inooponoonl conlial Lank, (40) woulo Lo ioplacoo Ly an inloiosl ialo solling iuloinlalion laigoling
iulo.
7
I.o. afloi all valuos lavo ioalisoo ano oxpoclalion opoialois can Lo omilloo.
15
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
Honco an inilial nol assol posilion in oolcil las lo Lo malcloo Ly llo piosonl oiscounloo valuo
of all fuluio govoinmonl liansfois lo Lo posilivo (
t
< 0) ano vico voisa.
3.5 Covernnent
In oui Lonclmaik moool, govoinmonl consumplion 'goos inlo llo ocoan' in llo sonso llal il
ooos nol piovioo any ulilily lo lousololos. Fuilloi, iovonuos aio nol usoo lo cuio inom cioncios
in llo oconomy, i.o. lloio is no olsolling of inom cioncios in oquiliLiium oulpul causoo Ly piicing
powoi of monopolislically compolilivo lims. Unooi llis assumplion llo govoinmonl Lalanco is
givon Ly
T
t

t
= 1
1,t
G
1,t
1
`,t
G
`,t
Q
t
(42)
Lxponoiluios covoi govoinmonl puiclasos on lomo piooucoo liaoaLlos 1
1,t
G
1,t
ano non-
liaoaLlos 1
`,t
G
`,t
as woll as lump sum liansfois Q
t
=
_

Q
)
t
d, lo lousololos (social Lonolls).
Fuilloi wo lavo assumoo llal govoinmonl oxponoiluios on llo liaoaLlo gooo only fall on lomo
pioouco. Lump sum laxalion T
t
=
_

T
)
t
d, ano liansfois fiom llo conlial Lank capluioo Ly
t
soivo as souico of lnancing.
Again wo iosliain fiom llo acknowloogoo facl, llal llo oosign of llo Lulgaiian cuiioncy
Loaio onlails, wlolloi inlonlionally oi nol, llo possiLilily llal llo govoinmonl conoucls mon-
olaiy policy lliougl ils ooposils in llo liaLilily sioo of llo issuo oopailmonl covoioo Ly
t
in
oui moool. So fai, lloio is no policy iulo in llo moool olloi llan lo immooialoly spono wlal is
oainoo fiom lump sum laxalion ano inloiosl incomo on foioign-cuiioncy oonominaloo Lonos.
8
3.6 ForeIgn Sector
3.6.1 \ncovered Interest IarIty
Maximising oxpocloo ulilily (1) will iospocl lo 1
1,t
, 1
1,t
in llo piivalo socloi Lalanco (2)
yiolos llo uncovoioo inloiosl paiily conoilion
1
t
[`
C
t
1
t
1
t
(1 i
t
) (1 i

t
)
o
t
o
t
[ = 0
Using llal fiom llo Luloi oqualion (18) wo gol 1
t
[`
C
t
1
I
1
I
[ =
A
C
I
oi
I

ano simplifying
0 = 1
t
[
`
C
t
,(1 i
t
)
(1 i
t
) (1 i

t
)
o
t
o
t
[
(1 i
t
) = (1 i

t
)1
t
o
t
o
t
(48)
In oui moool UII lolos up lo a iisk piomium. 1lo inloiosl ialo al wlicl lomo lousololo can
Loiiowlono inloinalionally (foi wlicl llo UII lolos) ano llo oxogonous woilo inloiosl ialo
aio linkoo Ly
(1 i

t
) = (1 i

t
)c[
1
t
1
t
[ (44)
wloio
1
I
1
I
oonolo nol ioal foioign assols (
1
I
1
I
= 0) ano nol ioal foioign liaLililios (
1
I
1
I
< 0),
iospoclivoly. Lqualion (44) onsuios llo slalionaiily of llo oconomy wlon oxposoo lo lompoiaiy
slocks, o.g. a woilo inloiosl ialo slock.
0
Wo fuilloi assumo llal in llo (inilial) oquiliLiium
llo inloiosl ialos convoigo wlicl ioquiios llal c[
1
1
[ = 1. 1loiofoio llo iisk piomium is 0 in
sloaoy slalo ano all sloil iun ialos in llo moool oqualiso.
8
Nolo llal soignoiago oainings cannol Lo sponl as unooi llo cuiioncy Loaio lloy moclanically fooo inlo
clangos in foioig iosoivos loloings, as (41) makos cloai.
0
Soo also Sclmill-Giolo ano UiiLo (2008) foi llis poinl.
16
D
P
/
6
0
/
2
0
0
7
3.6.2 Terns oI Trade and tLe InternaI HeaI ExcLange Hate
Ly oolnilion llo consumplion Lasoo inloinal ioal oxclango ialo in lovols is givon Ly llo oomoslic
cuiioncy piico of ono unil of llo liaoaLlos Laskol in unils of non-liaoaLlos
Q
t
=
1
T,t
1
`,t
(4)
1lo loims of liaoo aio givon Ly llo iolalivo piico of impoiloo gooos in loims of lomo piooucoo
liaoaLlos
T
t
=
1
1,t
1
1,t
=
o
t
1
1,t
(46)
Q
t
ano T
t
can Lo usoo lo slow low clangos in llo oxloinal compolilivonoss alocl oomoslic ioal
maiginal cosl in oacl socloi. Fiom (27) ano (20) wo oiioclly oLlain
1
`,t
1
1,t
=
(1 c
1
)
(1 c
`
)
'C
1
:
'C
`
:
1
1,t
1
`,t
1
`
:
1
1
:
(47)
oi
T

t
Q
t
=
(1 c
1
)
(1 c
`
)
'C
1
:
'C
`
:
1
1,t
1
1
:
1
`
:
1
`,t
(48)
A lompoiaiypoimanonl ioal oopiocialion (an incioaso in Q
t
) - coloiis paiiLus - oocioasos ioal
maiginal cosl in llo liaoaLlo socloi. 1lo samo olocl can Lo allainoo Ly an impiovomonl (a
oocioaso) in llo loims of liaoo T
t
. Fuilloimoio, an incioaso in llo pioouclivily of laLoui in
llo liaooo socloi causos a ioal appiocialion in Q
t
a ooloiioialion (an incioaso) in llo loims
of liaoo.
Oui moool onlails llo Lalassa-Samuolson olocl wlicl can Lo soon fiom log-linoaiising (47)
aiouno a zoio inlalion sloaoy slalo
j
1,t
|
1
t
:c
1
t
j
1,t
= j
`,t
|
`
t
:c
`
t
j
`,t
An incioaso in laLoui pioouclivily in llo liaooo-gooos socloi j
1,t
|
1
t
will loao lo an incioaso
in ioal maiginal cosl in llo non-liaooo socloi loaoing lo ligloi inlalion in llo non-liaooo gooos
socloi. 1lo lalloi can Lo soon fiom llo lyLiio Ilillips-cuivo givon Ly (88). Fuilloimoio, wo
can wiilo llo CII piico lovol (0) as
1
t
= o
t
(Q
t
)

(T
t
)

(40)
fiom wlicl il follows llal col. pai. a oopiocialion of llo ioal oxclango ialo (a iiso in Q
t
foi
llo slaio of liaoaLlos < 0.) oi a ooloiioialion of llo loims of liaoo oocioasos llo piico lovol
ano vico voisa.
3.6.3 Current Account
In an opon oconomy fiamowoik, llo oiloionco Lolwoon lolal incomo ano oomoslic consumplion
is oolnoo as llo cuiionl accounl. 1o oLlain lolal incomo, wo wiilo llo iosouico consliainls of
llo lomo oconomy in nominal loims
1
1,t
1
1,t
= 1
1,t
C
1,t
1
1,t
1
1,t
1
1,t
G
1,t
1
1,t
C

1,t
1
`,t
1
`,t
= 1
`,t
C
`,t
1
`,t
1
`,t
1
`,t
G
`,t
17
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
In oui fiamowoik, invoslmonl ano lnal oulpul in a socloi faco llo samo piico olaslicilios of
oomano ano lonco lavo llo samo oquiliLiium piico 1
1,`
t
1
`
t
= 1
`
t
1
`
t
ano 1
1,1
t
1
1
t
= 1
1
t
1
1
t
.
10
Fuilloi nolo llal 1
T,t
C
T,t
= 1
1,t
C
1,t
1
1,t
C
1,t
. 1o oLlain llo cuiionl accounl, wo aoo up
(2), (42), (80) ano lako inlo accounl llal aggiogalo oquiliLiium piolls in Loll soclois aio
H
1,t
= 1
1,t
1
1,t
\
1,t
1
1,t
1
1,t
1
1
t
1
1
t
H
`,t
= 1
`,t
1
`,t
\
`,t
1
`,t
1
`,t
1
`
t
1
`
t
Honco
1
1,t
o
t
1
1,t
'
t
T
t

t
Q
t
o
t
1
C
1,t
'
t
'
t
1
1,t
1
1,t
1
`,t
1
`,t
= 1
1,t
C
1,t
1
1,t
C
1,t
1
1,t
1
1
t
1
1,t
G
1,t
1
`,t
C
`,t
1
`,t
1
`
t
1
`,t
G
`,t
T
t

t
Q
t
'
t

1
1,t
1 i
t

o
t
1
1,t
1 i

o
t
1
C
1,t
1 i

t
7
t
7
t
Wo ovonlually oLlain
1
1,t
o
t
1
1,t
o
t
1
C
1,t
1
1,t
C

1,t
= 1
1,t
C
1,t

1
1,t
1 i
t

o
t
1
1,t
1 i

o
t
1
C
1,t
1 i

t
7
t
7
t
1lo nominal cuiionl accounl is llon llo lofl lano sioo of llo following oqualion
1
1,t
o
t
1
1,t
o
t
1
C
1,t
A
t
=
1
1,t
1 i
t

o
t
(1
1,t
1
C
1,t
)
1 i

t
7
t
7
t
(0)
wloio A
t
= 1
1,t
C

1,t
1
1,t
C
1,t
oonolos llo nominal liaoo Lalanco oxpiossoo in lomo cuiioncy.
On llo lofl lano sioo wo lavo llal llo cuiionl accounl is compiisoo of facloi incomo on Lonos
Lougll al llo ono of poiioo t 1 ano paio oul al llo Loginning of t as woll as nol liaoo.
3.6.4 HaIance oI aynents
1lo Lalanco of Iaymonls (LOI) is oolnoo as
1O1
t
C
t
1
t
77
t
= 0
Afloi ioaiianging (0) wo oLlain llo nominal Lalanco of paymonls:
1O1
t
(1)
1
1,t
o
t
1
1,t
o
t
1
C
1,t
A
t
(
1
1,t
1 i
t

o
t
(1
1,t
1
C
1,t
)
1 i

t
) (7
t
7
t
) = 0
wloio C
t
oonolos llo cuiionl accounl, 1
t
oonolos llo lnancial accounl ano 77
t
oonolos llo
foioign iosoivosoxclango Lalanco. 77
t
1
t
oquals llo clango in llo nol assol posilion of llo
oconomy wlicl is oqual lo llo cuiionl accounl. A (lompoiaiy) LOI suiplus 1O1
t
0 inoucoo
Ly a cuiionl accounl suiplus (an incioaso in nol oxpoilsnol facloi incomo) oi a lnancial accounl
oolcil (a nol capilal oxpoil) implios llal lloio is a vo clango in nol assols. 1lon lloio musl
Lo a nol incioaso in llo foioign iosoivos Lalanco, 77
t
0 wlicl unooi llo cuiioncy Loaio
lianslalos inlo an incioaso in oomoslic Laso monoy supply. Analogously, nol capilal impoils
10
A follow up papoi iolaxos llis assumplion, in oiooi lo sluoy FDI as inloimooialo gooo of pioouclion, soo
also Nalalucci ano Iavonna (2008).
18
D
P
/
6
0
/
2
0
0
7
(vo FDI inlows) causo foioign iosoivo inlows ano lavo a oxpansionaiy impacl on oomoslic
monoy supply. Wo soo llis moclanism oiioclly Ly omploying llo policy iulo (40)
1O1
t
C
t
1
t
= '
t
'
t
Donolo nol nominal foioign assols Ly 1
t
=
1
1,I
i
I

S
I
1
T,I
1
C
T,I

I
io assols acquiioo al llo ono of
poiioo t wlicl maluio al Loginning of poiioo t 1. In oui caso nol nominal foioign assols oqual
llo -vo lnancial accounl 1
t
= 1
t
, as llo full piincipal of lasl poiioo`s Lono puiclasos is
paio oul as inloiosl incomo ano lloiofoio only onlois llo cuiionl, Lul nol llo lnancial accounl.
Uso llo UII givon Ly (48) lo oLlain
1
t
=
1
1,t
o
t
(1 i

t
)1
t
o
t

o
t
(1
1,t
1
C
1,t
)
(1 i

t
)
1
t
o
t
1
t
o
t
1
t
=
1
1,t
o
t
(1 i

t
)1
t
o
t

o
t
(1
1,t
1
C
1,t
)1
t
o
t
(1 i

t
)1
t
o
t
1
t
(1 i

t
)
1
t
o
t
o
t
= 1
1,t
1
t
o
t
1
1,t
1
t
o
t
1
C
1,t
As ioluins on poiioo t 1 Lono loloings aio paio oul al Loginning of poiioo t wlon o
t
las
ioalisoo, wo can oiop oxpoclalions
11
1
t
(1 i

t
)
o
t
o
t
= 1
1,t
o
t
1
1,t
o
t
1
C
1,t
Iowiilo llo Lalanco of paymonls (1) lo oLlain llo ovolvomonl of nominal nol foioign assols
1
t
(1 i

t
)
o
t
o
t
A
t
1
t
= 7
t
7
t
1
t
= (1 i

t
)
o
t
o
t
1
t
A
t
(7
t
7
t
)
1
t
= (1 i
t
)1
t
A
t
(7
t
7
t
) (2)
wloio wo lavo llal if 1
t
0, lomo counliy las a posilivo nol foioign assol posilion lo aLioao
ano vico voisa. Wo can iowiilo llo nominal lnancial foioign assol posilion givon Ly (2) lo
oLlain a conoilion foi llo inloilompoial solvoncy of llo lomo counliy. Wo oolalo Ly llo CII
piico inoox lo oLlain llo ioal LOI in poiioo t
1
t
1
t
= (1 i
t
)
1
t
1
t
1
t
1
t

A
t
1
t
(
7
t
1
t

7
t
1
t
1
t
1
t
)
1
v
t
=
1 i
t
1
t
1
v
t
A
v
t
(7
v
t

7
v
t
1
t
) (8)
Solving foiwaio yiolos llo conoilion
1
v
t
=

:t
(
:

)t
(
1 i
)
1
)
)

)7
v
:

7
v
:
1
:
A
v
:
(4)
wloio wo lavo iuloo oul Ionzi-sclomos. 1lo inloilompoial nol assol posilion givos guioanco
foi llo inloilompoial suslainaLilily of cuiionl accounl oolcils unooi llo cuiioncy Loaio. If
11
Wo lavo nol lxoo llo nominal oxclango ialo o
I
in llis soclion lo allow foi compaiing oui iosulls will llo
iosulls unooi a small opon oconomy unooi a loxiLlo ialo.
19
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
llo oconomy is inilially (in llo inilial sloaoy slalo al oalo t 1) a nol Loiiowoi fiom aLioao,
i.o. 1
v
t
< 0 il nooos lo soll ioal foioign iosoivos anooi allain nol ioal liaoo suiplusos. 1lis
conoilion accounls foi llo facl llal llo oconomy - as lypical unooi llo oconomic liansilion
piocoss - mainlains a cuiionl accounl oolcil foi somo poiioo as il ooos nol nooo lo Lo fulllloo
ovoiy poiioo. 1lo conoilion only slalos llal llo piosonloo oiscounloo incomo low fiom solling
iosoivosincioasos in nol-liaoo lavo in sum lo Lo posilivo ano laigo onougl lo pay ol inilial
nol liaLililios lo aLioao.
4 TLe Steady State
1lo sloaoy slalo oosciiLos llo long-iun ooloiminislic oquiliLiium of llo oconomy wloio all
piicos aio loxiLlo ano oplimum oocisions of lousololos ano lims aio guiooo Ly iolalivo piicos
only. In oiooi lo slow llal llo long-iun oquiliLiium is slalionaiy ano uniquo, wo oxplain all
llo (ialios of) onoogonous ano slalo vaiiaLlos Ly oxogonous paiamolois only.
4.1 IrIcIng DecIsIon oI FIrns and Steady State IrIce LeveIs
In sloaoy slalo, all piicos aio loxiLlo ano lloiofoio llo piico-iosolling pioLaLilily foi foiwaio-
looking lims is 1 0
1
= 1 0
`
= 1. Wo oLlain sloaoy slalo valuos Ly omilling llo limo
suLsciipl fiom llo vaiiaLlos. Fiom (84) - (86) oiioclly follows llal
1
o
1
= 1

1
1
1
= 1

1
Ilugging in (86)
_
1
o
1
_
,
1
(1 .
1
) = (1 .
1
)
_
1
)
1
_
,
1
1
o
1
= 1
)
1
wlicl coincioos will llo iosull if lloio woulo Lo no Lackwaio-looking lims al all, io .
1
= 0.
1lo analogous iosull is oLlainoo foi llo socloi.
Will monopolislically compolilivo lims, llo sloaoy slalo ooos lowovoi nol yiolo llo lisl
Losl oulcomo. Maikol powoi causos oquiliLiium piicos lo Lo aLovo lloso of llo compolilivo
oulcomo wloio all lims aio piico lakois wlicl can Lo soon fiom
j
c
1
(.)
1
1
= 1 =
j
1
j
1
1
'C
1
'C
1
()
j
c
`
(.)
1
`
= 1 =
j
`
j
`
1
'C
`
'C
`
(6)
wloio
,
1
,
1

1 ano
,
^
,
^

1 aio llo socloi-spocilc Loinoi-inoicos of monopoly powoi ano

inoicalo llo maik-up claigoo ovoi ioal maiginal cosl. As llo piico olaslicilios of oomano 1 < j
1
,
j
`
< , lims iocoivo a maik-up ovoi ioal maiginal cosls. Foi j
1
, j
`
wo woulo oLlain
llo compolilivo 'lisl-Losl' iosull in Loll soclois wloio oulpul piicos iolocl ioal maiginal cosl.
Wo fuilloi assumo - willoul loss of gonoialily - llal 1
1
= 1
`
= o = \ = 1.
12
Wo oailioi
assumoo llal 1

1,t
= 1 ano Ly llo LOI 1

1,t
=
1
T,I
S
I
. Honco 1

1
= 1
1
= 1 ano j
c
1
(.) = j
c
`
(.) = 1
foi all lims .. Sloaoy slalo piico inoicos aio llon givon Ly
1
T
= (1
1
)

(1
1
)

= 1
1 = (1
T
)

(1
`
)

= 1
12
Nolo llal lxing piicos al any olloi aiLiliaiy lovol woulo Lo in lino will a zoio inlalion ialo sloaoy slalo.
20
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P
/
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0
/
2
0
0
7
4.2 TLe HeaI Sector
Wo oLlain fiom llo Luloi oqualion givon Ly (17) llal suLjoclivo ano maikol oiscounling aio
linkoo Ly
i =
1 ,
,
(7)
Wo fuilloi lno llal capilal accumulalion in sloaoy slalo is
1
`
= 1(
1
`
1
`
)1
`
(1 c)1
`
1
1
= 1(
1
1
1
1
)1
1
(1 c)1
1
c = 1(
1
`
1
`
)
c = 1(
1
1
1
1
)
Foi llo funclional foim of 1 wo assumo as in Gali ol al. (2004) llal 1(c) = c fiom wlicl follows
llal 1

(c) = 1 ano llal c =

1
1
1
1
=
1
^
1
^
. Fiom llo lalloi wo soo llal in long-iun oquiliLiium llo
slaio of now invoslmonl lo plysical capilal jusl oquals llo oopiocialion ialo of oxisling capilal
in oiooi lo loavo llo capilal slock of llo oconomy conslanl. Nominal ano ioal ialo of ioluins
aio linkoo Ly
(1 i) =
,
1 ,(1 c)
1
1
=
,
1 ,(1 c)
1
`
As Loll soclois faco llo samo oopiocialion ialo c of ioal capilal, ioal ioluins on plysical capilal
lavo lo oqualiso in sloaoy slalo. Fiom llo iosouico consliainl in llo liaoaLlo socloi
1 =
C
1
1
1
c
1
1
1
1

G
1
1
1

1
1
1
Ly llo facloi oomanos foi plysical capilal (28) ano (80) wo oLlain llo capilal oulpul ialios
1
1
1
1
= (
1
c
1
1 ,(1 c)
,
j
1
j
1
1
)

(8)
1
`
1
`
= (
1
c
`
1 ,(1 c)
,
j
`
j
`
1
)

(0)
wloio wo usoo llal lims` ioal maiginal cosls in sloaoy slalo is
,
1

,
1
ano
,
^

,
^
iospoclivoly.
Honco sloaoy slalo invoslmonlcapilal ialios aio llo samo in Loll soclois. Fiom llo laLoui
oomanos givon Ly (27) ano (20) wo iocovoi llo laLoui slaios
1
1
1
1
= (
1
1 c
1
j
1
j
1
1
)

(60)
1
`
1
`
= (
1
1 c
`
j
`
j
`
1
)

(61)
Fiom aggiogalo supply in llo oconomy wo oLlain llo capilal-laLoui ialio in Loll soclois
1
1
1
1
= (
1
1
1
1
)

o
1
= (
1
1 c
1
j
1
j
1
1
)

o
1
1
`
1
`
= (
1
`
1
`
)

o
1
= (
1
1 c
`
j
`
j
`
1
)

o
^
21
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
wloio wo lavo aggiogaloo ovoi llo avoiago lim` s pioouclion ano usoo llal Ly assumplion

1
=
`
= 1. 1lo sloaoy slalo consumplion slaios
C
1
Y
1
ano
C
^
Y
^
aio uniquoly ooloiminoo Ly
oxogonous vaiiaLlos ano paiamolois wlicl follows fiom
1 =
C
1
1
1
c(
1
c
1
1 ,(1 c)
,
j
1
j
1
1
)

G
1
1
1

1
1
1
C
1
1
1
= 1 c(
1
c
1
1 ,(1 c)
,
j
1
j
1
1
)

G
1
1
1

1
1
1
(62)
C
`
1
`
= 1 c(
1
c
`
1 ,(1 c)
,
j
`
j
`
1
)

G
`
1
`
(68)
wloio llo govoinmonl slaios
G
1
Y
1
,
G
^
Y
^
ano llo oxpoil quola
C

1
Y
1
aio sol oxogonously.
4.3 Current Account and HaIance oI Iaynents
In (1) wo oLlainoo llo Lalanco of paymonls ano llal in sloaoy slalo
1
1
o1
1
o1
C
1
A (
1
1
1 i

o(1
1
1
C
1
)
1 i

) (7 7) 0 (64)
i
1 i
1
1

i

1 i

(1
1
1
C
1
) = A (6)
Fiom llo iisk piomium oqualion (44) follows llal c[1[ = 1. Honco in sloaoy slalo lomo
lousololos can Loiiow al llo woilo inloiosl ialo
i

= i

ano all nominal inloiosl ialos oqualiso, i = i

= i

. 1lon sloaoy slalo nol lnancial assols can

Lo wiillon as
i

1 i

(1
1
1
1
1
C
1
) = A
Wo can oxpioss llis sloaoy slalo iolalionslip in loims of unils of llo lomo piooucoo liaoaLlo
oulpul
i

1 i

(
1
1
1
1
1
C
1
1
1
) = (
C

1
C
1
1
1
)
Ioal nol lnancial assols oqual nominal nol lnancial assols in sloaoy slalo ano can Lo oLlainoo
Ly omilling all limo suLsciipls fiom (8)
A
1
=
, 1
,
< 0 (66)
1lo lalloi oqualion implios llal if llo sloaoy slalo lnancial assols 1 aio -vo lloy lavo lo Lo
olsol Ly a vo nol liaoo Lalanco A in oiooi lo yiolo a Lalancoo nol lnancial assol accounl in
long-iun oquiliLiium ano vico voisa.
18
1lon llo sloaoy slalo iosoivos lo assol ialio
Z
1
las lo Lo
-vo as woll. In olloi woios in sloaoy slalo llo cuiionl accounl las lo Lo Lalancoo. Olloiwiso
wo woulo lavo inooloiminacy of llo long-iun oquiliLiium.
18
Wo coulo lavo also imposoo long-iun oquiliLiium on (4) lo oLlain llo samo sloaoy slalo iolalionslip.
22
D
P
/
6
0
/
2
0
0
7
5 CaIILratIon
Wo caliLialo oui moool foi quailoily oala.
14
Iogaioing piofoioncos, lousololo`s oiscounl facloi
is sol lo , = 0.00 implying a quailoily zoio inlalion sloaoy slalo inloiosl ialo of

o
100/ = 1.01/
ano an oloclivo annual inloiosl ialo of 4.1/. Wo sol llo Fiiscl olaslicily of laLoui supply

i
lo

as in Nalalucci ano Iavonna (2008). Following Valov (200) wlo iolios on oala fiom llo 1007
Lulgaiian inpul-oulpul maliix wo assumo llal piofoioncos aio lilloo lowaios llo non-liaooo
gooo loaoing lo a slaio of non-liaooo oi soivico consumplion of 1 = 0.408. Foi llo slaio
of lomo piooucoo gooos in llo liaoaLlos Laskol wo sol = 0.2 as in Nalalucci ano Iavonna
(2008) wlo oslimaloo llo lalloi foi llo Czocl oconomy. Foi llo laLoui supplios lo oacl socloi
wo assumo llal
1
^
1
=
1
1
1
= 0..
As Locomos visiLlo of llo log-linoaiisoo moool lo Lo slown in llo apponoix, oynamics
oopono on llo inilial assol posilion of llo oconomy. Fiom llo Lxloinal Soclois Inoicalois of llo
Lalanco of Iaymonls slalislics of llo LNL wo oLlain llo LNL foioign iosoivos lo assol ialio.
1
Wo avoiago llo ialio foi llo limo span 1000 2008 wlicl yiolos
Z
1
= 0.0 as llo sloaoy slalo
valuo. Fuilloi, nol oxloinal ooLl lo GDI avoiagoo ovoi llo samo limo span is 88.1/. In
llo aLsonco of spocilc oala wo assumo llal lomo piooucoo liaoaLlo GDI amounls lo lalf of
lolal GDI fiom wlicl wo can pioxy llal
1
Y
1
is oqual lo 0.6. Wo sol oxpoils as slaio of nol
liaoo
C

1
`A
lo 8,2, lloioLy oopailing laigoly fiom llo ompiiical avoiago Lulgaiian valuo givon
Ly 8.4 foi llo consiooioo limo span. Lmploying llo valuo lakon fiom llo oala woulo inouco
non-slalionaiily in llo moool, i.o. lloio woulo Lo no lo ioluin lo llo inilial sloaoy slalo afloi
lompoiaiy slocks.
16
Wo sol llo limo-invaiianl iisk piomium givon Ly oqual lo poiconl.
Concoining oomoslic pioouclion, llo quailoily oopiocialion ialo of plysical capilal is sol lo
llo slanoaio valuo of c = 0.02. As in Nalalucci ano Iavonna (2008) llo olaslicily of 1oLin`s Q
will iospocl lo llo invoslmonl-capilal ialio is 0. in Loll pioouclion soclois. Wo assumo llal
lomo liaoaLlo pioouclion loclnology is lwico as capilal inlonsivo as in llo non-liaooo socloi,
i.o. c
1
= 0.67 ano c
`
= 0.88.
1lo piico solling-pioLaLililios 0
`
, 0
1
ano llo slaio of Lackwaio looking lims c
`
, c
1
ooloimino llo claiacloiislics of llo inlalion oynamics in llo iospoclivo socloi. Lslimalos of
socloi-spocilc lyLiio inlalion oynamics foi Lulgaiia aio aLsonl so fai. Wo uso - nol-socloi
spocilc - oslimalos fiom Lonovai (200) foi llo caso of Hungaiy, wlicl soivo as a pioxy foi
inlalion oynamics in liansilion oconomios. 1lo aulloi lnos llo slaio of Lackwaio looking
lims lo Lo in llo inloival of [0.8, 0.[, lonco wo sol c
`
= c
1
= 0.4. 1loiofoio, llo slaio
of foiwaio-looking lims oominalos in Loll soclois. 1lo oslimaloo pioLaLilily in any poiioo
llal a lim cannol iosol ils piico is in llo inloival Lolwoon 0.4 lo 0.6, lonco wo assumo
0
`
= 0
1
= 0. lo Lo ioasonaLlo valuos. 1lo solling implios llal llo avoiago ouialion of piico
conliacls - wlicl is a moasuio of llo nominal iigioily in oacl socloi - foi llo non-liaooo socloi
Locomos 1
`
=

v
^

0
^
= 8.7 quailois, llo samo in llo liaooo gooos socloi. In olloi woios,
il lakos aiouno ono yoai foi piicos lo aojusl lo now infoimalion.
Lslimalos of oquiliLiium maik-ups in Lulgaiian manufacluiing soclois foi llo limo-span
100 2001 aio pioviooo in DoLiinsky ol al. (2004). Wo oxliacl an avoiago valuo aiouno
1.2 ano assumo llal llo maik-up is samo foi Loll soclois. In olloi woios, lims claigo in
oquiliLiium piicos wlicl aio 20/ aLovo ioal maiginal cosl. Fiom () ano (6) wo llon oLlain
llo piico olaslicilios of oomano j
1
= j
`
= 6.
Govoinmonl consumplion is sol lo 10 poiconl of socloi-spocilc oulpul.
14
1lo oolailoo sol of llo caliLialoo paiamolois can Lo oLlainoo fiom apponoix A on pago 26.
1
LNL iosoivo assols (in mio Luio) nol oxloinal ooLl (in mio Luio), soo LNL (2006).
16
1loso assumplions lavo somo implicalions foi olloi slaios in llo oxloinal socloi in long-iun oquiliLiium.
Fiom (66) follows llal llo cuiionl accounl A i1 las lo Lo Lalancoo in sloaoy slalo wlicl ioquiios
^^
Y

T
Y

= 0.0061. Foi
C

^^
= 82 wo oLlain llal
C

=
C

^^
^^
Y

0.0061 = 0.0002.
23
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
6 EcononIc IoIIcy anaIyses
6.1 TLe HaIassa-SanueIson eect under tLe Currency Hoard
1lo Lalassa-Samuolson (LS) lypollosis suggosls llal ligloi facloi pioouclivily in liaoaLlos
llan non-liaoaLlos pioouclion - lypical foi llo calcl-up piocoss - will conliiLulo lo an incioaso
of inlalion in non-liaoaLlos.
17
Unooi llo cuiioncy Loaio, llo nominal oxclango ialo cannol
aojusl lo aLsoiL llo piossuio on llo ioal oxclango ialo inoucoo Ly llo iiso in liaooo-gooos
pioouclivily causing oomoslic ovoiall inlalion ialo lo incioaso. 1o consliucl llo LS-olocl wo
assumo llal liaoaLlo facloi pioouclivily in llo liaoaLlo socloi
1,t
giows in oxcoss of
`,t
lill il ioaclos ils sloaoy slalo valuo
1
= 1. Non-liaooo socloi pioouclivily iomains al ils
sloaoy slalo valuo
`
= 1 lliougloul. Foi an aulocoiiolalion coom cionl in llo lolal facloi
pioouclivily piocoss of j
Y
1
= 0.8 wo allain llal afloi appioximaloly 24 quailois, oi 6 yoais

1
will lavo ioluinoo lo ils sloaoy slalo valuo.
18
-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
Impulse responses to a shock in tfp home tradables
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
total consumption
labour supply home trad
labour supply non trad
output home trad
output home non-trad
Figuio 1: Ioal Socloi
Figuios 1 lo 8 illuslialo oovolopmonls in llo ioal, lnancial, ano oxloinal socloi following llo
LS slock. Fiom 1 wo soo llal lloio is poisislonl ligloi giowll of ioal oulpul in llo liaoaLlo
socloi. 1lo lumpoo-slapoo iosponso can Lo alliiLuloo lo llo piosonco of cosls in clanging
llo inilial slock of capilal. 1lo impiovoo om cioncy of lims in llo liaooo-gooos socloi couploo
will lxoo oulpul oomano ouo lo llo piico iigioily iosulls in inilially loss laLoui oomano in llo
liaoaLlo socloi. 1lo ligloi pioouclivily iooucos ioal maiginal cosl in llo liaoaLlo socloi ano il
is piollaLlo foi lims wlicl aio aLlo lo iosol piicos lo lowoi piicos in oiooi lo soll moio causing
a oiop in liaoaLlo inlalion. Higloi pioouclivily allows foi ligloi ioal wagos in llo H socloi
ano ouo lo laLoui moLilily acioss llo soclois ioal wagos in llo socloi will incioaso as woll.
1lo lalloi can only Lo accomplisloo Ly ligloi lnal gooos piicos in llo non-liaoaLlo socloi
gonoialing llo inilial suigo in nonliaoaLlo inlalion. 1lis olocl Locomos visiLlo fiom lguio 2
wloio llo iosponso in inlalion is lumpoo-slapoo ouo lo llo piosonco of Lackwaio-looking lims
in llo socloi llal cannol aojusl piico-solling immooialoly.
17
Avoiago pioouclivily giowll fiom 1000 200 in Lulgaiia was .70 foi llo liaoaLlos ano 1.1S foi llo
non-liaoaLlo socloi (soo Dimiliova 2006, foillcoming).
18
As in (Nalalucci ano Iavonna, 2008, ) no olloi slock alocls llo oconomy in suLsoquonl poiioos ano llo
inilial slock al t = 0 gonoialos llo onliio oynamics.
24
D
P
/
6
0
/
2
0
0
7
-1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Impulse responses to a shock in tfp home tradables
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
inflation home trad
inflation non trad
tobins q trad
tobins q non trad
cpi inflation
nom interest rate
real money balance
nom money supply
Figuio 2: Financial socloi
As incioasos in non-liaoaLlo inlalion oulwoigl inilial oocioasos in lomo-liaoaLlo inlalion,
lloio is a nol incioaso in CII inlalion. 1lo impacl of llo LS slock on CII inlalion is nol
llal pionouncoo ano slails oying oul afloi 2 yoais as movomonls in H ano inlalion ialos
slail componsaling foi oacl olloi. 1lo olocl of llo pioouclivily gain in llo H socloi on llo
ioal oxclango ialo is moio pionouncoo loaoing lo a laigo poisislonl appiocialion illuslialoo in
lguio 8. 1lo iosull llal llo olocl on llo ILLI is way moio poisislonl llan on llo oomoslic
inlalion ialos can Lo oxplainoo Ly llo incioaso in liaoaLlo consumplion causoo Ly ligloi
liaoaLlo oulpul.
10
-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
Impulse responses to a shock in tfp home tradables
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
real net financial assets
real foreign reserves
real trade balance
real exchange rate
terms of trade
Figuio 8: Lxloinal Socloi
10
Nolo llal llo ILLI can Lo wiillon as q
I
= c
^,I
c
T,I
. Following llo LS-slock lloio is a poisislonl suigo
in liaoaLlo consumplion.
25
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
1lo pioouclivily slock impiovos llo lnancial socloi sonlimonl givon Ly 1oLin` s Q in llo
iospoclivo soclois wlicl Locomos cloai fiom lguio 2. 1lo impiovomonl in llo oomoslic lnancial
maikol climalo Ly llo suigo in llo maikol valuo of capilal ovoi ils ioplacomonl cosls in llo H
socloi impiovos llo nol assol posilion of llo oconomy. 1lo Lalanco of paymonl luins lompoiaiily
inlo suiplus Ly llo iospoclivo incioaso in llo nol lnancial woalll as can Lo soon fiom lguio 8.
1lo accumulalion of ioal foioign iosoivos causos a oomoslic monolaiy oxpansion wlicl incioasos
loloings of ioal casl Lalancos ano oocioasos llo sloil-iun inloiosl ialo, fuilloi conliiLuling
lo llo incioaso in lolal consumplion. As lloio is a posilivo clango in nol foioign iosoivos, llo
cuiionl accounl is in suiplus ano woalll olocls fiom facloi incomo oominalo llo visiLlo oocioaso
in llo ioal liaoo Lalanco.
Concoining complianco will llo LU Accossion Ioquiiomonls, wo oLlain llal foi llo givon
caliLialion lloio woulo Lo no laim oono Ly llo LS olocl iogaioing llo fullllmonl of llo
Maasliicll inlalion ialo ano sloil-loim inloiosl ialo ciiloiia. Oui moool lloiofoio givos somo
inluilion foi llo ompiiically acknowloogoo facl llal llo conliiLulion of llo LS olocl lo oomoslic
inlalion is nol ossonlial (soo Dimiliova 2006 foi llo ompiiical ovioonco). In iolaloo iosoaicl,
Nalalucci ano Iavonna (2008) lno llal non-cuiioncy Loaio lxoo oxclango ialo accossion coun-
liios llal aio oxposoo lo a LS lypo slock faco ligl inlalion in llo non-liaoaLlo socloi llal
puslos CII inlalion up, woll Loyono llo Maasliicll limil. Wo lloiofoio oLlain ovioonco llal
inlalionaiy ano inloiosl ialo poifomanco unooi llo cuiioncy Loaio is supoiioi lo llo lxoo
oxclango ialo iogimo. Howovoi, willoul a iicloi lscal sioo foaluiing llo possiLilily of lscal
oolcils ano llo Luilo-up of govoinmonl ooLl wo cannol oiaw any fuilloi conclusions fiom oui
sliucluial fiamowoik iolaling lo llis poinl.
6.2 HeaI Convergence and tLe HeaI ExcLange Hate In tLe Long-Hun
In oiooi lo invosligalo long-iun suslainaLilily issuos wo oxposo oui moool lo a poimanonl 1FI
slock in llo H socloi. Fiom lguio 4 wo soo llal in llo long-iun, llo inloinal ioal oxclango ialo
appiocialion is pionouncoo. 1lo iolalivo piico of non-liaoaLlos incioasos Ly aiouno 7/ in llo
long iun ano is accompanioo Ly a liansiloiy ano oocioasing impiovomonl in llo ioal nol lnancial
assol posilion. Housololos lloiofoio incioaso lloii liaoaLlo ano non-liaoaLlo consumplion Ly
aiouno 7/ ano 4/ iospoclivoly Ly oo-accumulaling lloii lifolimo woalll. Lvonlually, ligloi
ovoiall consumplion al sloaoy slalo sloms solomnly fiom ligloi sloaoy slalo oulpul maoo
possiLlo Ly ligloi facloi pioouclivily in llo H socloi.
6.3 FIscaI IoIIcIes and tLe Trade HaIance
1uining lo llo oomano sioo wo invosligalo llo impacl of a liansiloiy incioaso in govoinmonl
sponoing in llo ano H socloi, iospoclivoly. 1lo slanoaio lox-piico ILC closoo-oconomy
fiamowoik piooicls a ooclino in lolal consumplion in iosponso lo a iiso in govoinmonl sponoing.
Iicaioian consumois consumo oul of lifo-limo woalll ano lloy smooll away incomo luclualions
causoo Ly llo inilial suigo in govoinmonl sponoing. 1lis iosull is also visiLlo in oui slicky-piico
opon oconomy moool as Locomos cloai fiom lguios ano 6. Wo fuilloi can oxliacl llo impacl
of govoinmonl sponoing on llo ioal nol foioign assol posilion of llo oconomy.
1uining lo lguio wo soo llal a lompoiaiy lscal policy slock incioasos lomo liaoaLlo
inlalion ano appiocialos llo loims of liaoo causing a loss in oxloinal compolilivonoss. 1lo
ligloi inlalion liiggoioo Ly oomano sioo piossuios conliacls llo ioal oomoslic Laso monoy
supply wlicl unooi llo cuiioncy Loaio moclanism loaos lo a ono-foi-ono loss in ioal iosoivo
loloings. Do-accumulalion in iosoivos iosulls in a ooloiioialion of llo inloilompoial foioign
assol posilion. Housololos foiosoo lloii loss in lifo-limo woalll ano smooll llo olocl away Ly
inilially oocioasing lolal consumplion. Following llo slock, lomo liaoaLlo oulpul incioasos
ano as oomoslic aLsoiLlion Ly lousololos oocioasos, a posilivo nol liaoo Lalanco Luilos up.
20
20
1lo impulso iosponso of socloi-spocilc oulpul ano lolal consumplion is omilloo fiom Loll giapls lo onlanco
26
D
P
/
6
0
/
2
0
0
7
-2 0 2 4 6 8 10
-8
-6
-4
-2
0
2
4
6
8
10
12
Impulse responses to a shock in tfp home tradables
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
real net financial assets
tradable consumption
non-trad cons
real money balance
real exchange rate
Figuio 4: Long iun oovolopmonl of llo ILLI ano llo oxloinal assol posilion
-1 -0.5 0 0.5 1 1.5 2 2.5 3
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
Impulse responses to a shock in govt cons home trad
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
inflation home trad
inflation non trad
real net financial assets
real foreign reserves
real trade balance
real exchange rate
terms of trade
Figuio : Lxloinal socloi afloi a poisislonl incioaso in govoinmonl liaoaLlo consumplion
27
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
-1 -0.5 0 0.5 1 1.5 2 2.5 3
-0.02
-0.015
-0.01
-0.005
0
0.005
0.01
Impulse responses to a shock in govt cons non trad
Years after shock
P
e
r
c
e
n
t

d
e
v
i
a
t
i
o
n

f
r
o
m

s
t
e
a
d
y

s
t
a
t
e
inflation home trad
inflation non trad
real net financial assets
real foreign reserves
real trade balance
real exchange rate
terms of trade
Figuio 6: Lxloinal socloi afloi a poisislonl incioaso in govoinmonl non-liaoaLlo consumplion
As lloio is an ovoiall loss in iosoivos, llo inloilompoial loss in nol woalll of llo oconomy
oominalos.
1uining lo lguio 6, wo soo llal mainly llo samo qualilalivo conclusions aiiso if govoinmonl
oxponoiluios fall on soivicos, i.o. consumplion. 1lo singlo main oiloionco lios in llo oovolop-
monl in llo ioal oxclango ialo. 1lo inilial suigo in sponoing causos an incioaso in non-liaoaLlo
inlalion ano lonco lo a iiso in llo iolalivo piico of non-liaoaLlos. Wo soo llal llo ioal oxclango
ialo appiocialion is loss poisislonl llan llo oovolopmonl in llo lomo non-liaoaLlo inlalion. Il
lonco luins oul llal govoinmonl oxponoiluios llal fall on non-liaooo gooos ialloi llan liaooo
gooos conliiLulo lo llo woisoning in oxloinal compolilivonoss liiggoioo Ly llo LS olocl.
7 ConcIusIons
1lo papoi invosligaloo llo liansmission of pioouclivily ano lscal slocks unooi llo cuiioncy
Loaio moclanism willin a Now Opon Lconomy Maciooconomic moool caliLialoo lo llo Lul-
gaiian oconomy. Wo founo llal inlalionaiy piossuios iosulling fiom ioal calcl-up piocossos
will nol lavo an poisislonl impacl on ovoiall CII inlalion ano will lloiofoio nol piovonl com-
plianco will llo Maasliicll inlalion ciiloiion. Novoilloloss a poisislonl appiocialion in llo
ioal oxclango ialo is visiLlo. Fiscal sponoing in oilloi socloi las a posilivo sloil iun impacl
on llo liaoo Lalanco Lul slill loaos lo cuiionl accounl oolcils ouo lo llo long-iun woisoning of
llo nol foioign assol posilion. Wlon lscal sponoing falls on llo liaooo (non-liaooo) gooos, a
lasling ioal oopiocialion (appiocialion) of llo ioal oxclango ialo slows up.
Foi a full assossmonl of llo ioaoinoss of llo Lulgaiian oconomy foi soon LIM II ano Luio-
aioa accossion onliy moio woik nooos lo Lo oono on llo lscal socloi of llo moool wlicl migll
alocl llo liansmission of slocks. Inlioouclion of a piopoilion of non-Iicaioian lousololos
wlo consumo oul of cuiionl insloao of poimanonl incomo can loao lo oiloionl iosulls iogaioing
llo olocls of lscal sponoing. Monolaiy slaLilisalion policios maoo possiLlo Ly oiawing fiom
govoinmonl ooposils in llo conlial Lank lavo lo Lo invosligaloo. 1lo cuiionl iosulls migll also
Lo clallongoo if oiloionl oogioos of pass-lliougl of foioign lo oomoslic inlalion aio inliooucoo.
claiily of llo oxposilion.
28
D
P
/
6
0
/
2
0
0
7
Lvonlually, llo iolo of foioign oiiocl invoslmonl as inloimooialo gooo in liaoaLlo gooos pioouc-
lion las lo Lo sluoioo. Novoilloloss llo moool sol up loio can soivo as a lisl slop lowaios a
fulloi lioalmonl of analysing Lulgaiia` s iappioclomonl lo llo Luio-zono willin llo fiamowoik
of llo Now Opon Lconomy Maciooconomics.
TecLnIcaI AendIces
A CaIILratIon
Iaraneters caIILrated Ior QuarterIy Data
Dosciiplion Iaiamoloi Valuo Souico
iisk piomium 0.0
slaio of lomo-liao in liao Laskol i 0.2 Nalalucci ano Iavonna (2008)
slaio of liao in consum Laskol 0.01 Valov (200)
invoiso of olaslicily of laLoui supply i 2 Nalalucci ano Iavonna (2008)
oopiocialion ialo of plysical capilal c 0.02 ILC
oomano olaslicily of H consumplion j
1
6 DoLiinsky ol al. (2004)
oomano olaslicily of consumplion j
`
6 DoLiinsky ol al. (2004)
lousololo`s oiscounl facloi , 0.00 ILC
slaio of capilal in lomo liao pioouclion c
1
0.67 Nalalucci ano Iavonna (2008)
slaio of capilal in non-liao pioouclion c
`
0.88 Nalalucci ano Iavonna (2008)
olaslicily of invoslmonl-capilal ialio j 0. Nalalucci ano Iavonna (2008)
slaio of Lackw-looking lims in H socloi c
1
0.4 Lonovai (200)
slaio of Lackw-looking lims in socloi c
`
0.4 Lonovai (200)
piico iosolling pioLaLilily in H socloi 1 0
1
0.4 Lonovai (200)
piico iosolling pioLaLilily in socloi 1 0
`
0.4 Lonovai (200)
ul. scalo paiamoloi ioal monoy Lalancos 0.00 Honiiksson (200)
sloaoy slalo ialio iosoivos lo assols
Z
1
0.0 LNL (2006)
sloaoy sl slaio of laLoui supply in H socloi
1
1
1
0.
sloaoy sl slaio gov`l H consumplion
G
1
Y
1
0.1 Nalalucci ano Iavonna (2008)
sloaoy sl slaio gov`l consumplion
G
^
Y
^
0.1 Nalalucci ano Iavonna (2008)
sloaoy sl slaio oxpoils lo nol liaoo Lalanco
C

1
`A
8,2
coom cionlH pioouclivily piocoss j
Y
1
0.8, 1 Nalalucci ano Iavonna (2008)
coom cionl pioouclivily piocoss j
Y
^
0.8, 1 Nalalucci ano Iavonna (2008)
coom cionlH liaoaLlos govl. consumplion j
G
1
0.48, 1 Nalalucci ano Iavonna (2008)
coom cionl non-liao govl. consumplion j
G
^
0.48, 1 Nalalucci ano Iavonna (2008)
coom cionl oxloinal oomano piocoss j
C

1
0.8, 1
coom cionl LMU inloiosl ialo piocoss j
i
0.0, 1 Nalalucci ano Iavonna (2008)
29
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
InIIed Steady State YaIues
Dosciiplion Iaiamoloi Valuo
Homo Consumplion lo Oulpul H socloi
C
1
Y
1
0.40824
Homo Consumplion lo Oulpul socloi
C
^
Y
^
0.70414
Invoslmonl lo Oulpul H socloi
1
1
Y
1
0.80766
Invoslmonl lo Oulpul socloi
1
^
Y
^
0.1086
sloaoy slalo maik-up H socloi (
,
1

,
1
)

1.2
sloaoy slalo maik-up socloi (
,
^

,
^
)

1.2
Capilal lo Oulpul ialio H socloi
1
1
Y
1
1.006
Capilal lo Oulpul ialio socloi
1
^
Y
^
7.884
Lxpoils lo lomo piooucoo gooos
C

1
Y
1
0.0001
H Exogenous stocLastIc rocesses
Foi socloi spocilc lolal facloi pioouclivily (1FI) of llo H socloi wo assumo

1,t
= oxp[j
Y
1
a
1,t
-
Y
1
,t
[
Analogously foi llo socloi 1FI

`,t
= oxp[j
Y
^
a
`,t
-
Y
^
,t
[
Govoinmonl oomano comos fiom
G
1,t
= oxp[j
G
1
a
G
1
,t
-
G
1
,t
[
G
`,t
= oxp[j
G
^
a
G
^
,t
-
G
^
,t
[
Ano oxloinal oomano follows
C

1,t
= oxp[j
C

1
a
C

1
,t
-
C

1
,t
[
1lo oiioi loims in oacl piocoss lavo log-noimal nio(0,1) oisliiLulions.
C TLe Iog-IInearIsed nodeI
1lo log-linoaiisoo moool is givon Ly llo following sol of oqualions, wloio wo lavo alioaoy usoo
llal unooi llo cuiioncy Loaio -
t
= 0 al all oalos. Wo can ioouco llo numLoi of vaiiaLlos Ly
suLsliluling oul all piico lovol vaiiaLlos, i.o. cpi piico lovol j
t
, lomo liaooo piico lovol j
1,t
, non-
liaooo piico lovol j
`,t
as woll as liaooo gooos piico lovol j
T,t
. Nolo llal 1
t
j
t
j
t
= 1
t

t
,
analogously foi H, ano T.
30
D
P
/
6
0
/
2
0
0
7
on-ExectatIonaI EquatIons
0 = c
t
c
T,t
(1 )c
`,t
0 = c
T,t
c
`,t

1
1
i
t

1
1
c
t

1
1
:
t
(

1
)c
1,t
(

1
)c
1,t
0 = j
1,t
a
1
t
c
1
/
1
t
(1 c
1
)|
1
t
0 = j
`,t
a
`
t
c
`
/
`
t
(1 c
`
)|
`
t
0 = j
1,t

C
1
1
1
c
1,t

1
1
1
1
i
1,t

G
1
1
1
q
1,t

1
1
1
c
1

,t
0 = j
`,t

C
`
1
`
c
`,t

1
`
1
`
i
`,t

G
`
1
`
q
`,t
0 = |
t

1
`
1
|
`
t

1
1
1
|
1
t
0 = n
t
i
t
:
t
(i 1)|
t
0 = n
v
t
n
t
i
t
c
t
:
t
0 = /
1
t
ci
1
t
(1 c)/
1
t
0 = /
`
t
ci
`
t
(1 c)/
`
t
0 =
1
t
ji
1
t
j/
1
t
0 =
`
t
ji
`
t
j/
`
t
0 =

`
C
t

1,t

t
(1 ,(1 c))r
1
t
,
1
t

`
C
t

1
t
0 =

`
C
t

`,t

t
(1 ,(1 c))r
`
t
,
`
t

`
C
t

`
t
0 =

`
C
t
c
t
0 = r
1
t
:c
1
t
j
1
t
/
1
t
0 = r
`
t
:c
`
t
j
`
t
/
`
t
0 =
t

T,t
(1 )
`,t
0 =
T,t

1,t
0 = i

t
i
t
0 = i

)
v
t
0 = )
v
t

1
,
)
v
t

1
,
i
t
(
1
,

7
1
)
t

1 ,
,
:r
t

(1 ,)( 1)
,

t

(1 ,)
,
t
t

7
1
.
v
t

7
1
.
v
t
0 = )
t
)
v
t
i
t
c
t
:
t
0 = :r
t

1
A
c
1

,t

C

1
A
c
1,t
(
C
1
A

C

1
A
)c
1,t
0 = :r
v
t
:r
t
t
t
0 =
t
c
T,t
c
`,t
0 = t
t
c
1,t
c
1,t
0 = :
v
t
i
t
c
t
0 = :
t
.
t
31
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
ExectatIonaI equatIons
0 = 1
t
c
t
c
t
i
t
1
t
j
t
j
t
0 = 1
t
c
1,t
c
1,t
i
t
1
t
j
1,t
j
1,t
0 = 1
t
c
`,t
c
`,t
i
t
1
t
j
`,t
j
`,t
0 = `
)
1
1
t

1,t

1,t
`
nc
1
:c
1,t
`
o
1

1,t
0 = `
)
`
1
t

`,t

`,t
`
nc
`
:c
`,t
`
o
`

`,t
Exogenous stocLastIc rocesses
1
t
a
1,t
= j
Y
1
a
1,t
1
t
-
Y
1
,t
1
t
a
`,t
= j
Y
^
a
`,t
1
t
-
Y
^
,t
1
t
q
1,t
= j
G
1
q
1,t
1
t
-
G
1
,t
1
t
q
`,t
= j
G
^
q
`,t
1
t
-
G
^
,t
1
t
c

1,t
= j
C

1
c

1,t
1
t
-
C

1
,t
1
t
i

t
= j
i
i
t
1
t
-
i

,t
32
D
P
/
6
0
/
2
0
0
7
References
Benigno, G. and C. Thoenissen (2003). Equilibrium Exchange Rates and Supply-side
Performance. The Economic Journal 113 (486), C103C124.
BNB (2006). External Sector Indicators Database of the Bulgarian Economy. Available
from the Bulgarian National Bank website.
Bokil, M. (2005). Fear of Floating: An Optimal Discretionary Monetary Policy Analysis.
Mimeographed.
Desquilbet, J. B. and N. Nenovsky (2003). Exploring the Currency Board Mechanics:
a Basic Formal Model. National Bank of Bulgaria Discussion Papers. DP/35/2003.
Dimitrova, K. (2006). Balassa-Samuelson Estimates for the Bulgarian Economy.
National Bank of Bulgaria, unpublished report.
Dobrinsky, R., G. Koroesi, N. Markov, and L. Halpern (2004). Firms Price Markups
and Returns to Scale in Imperfect Markets: Bulgaria and Hungary. William Davidson
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Gali, J. and M. Gertler (1999). Inflation Dynamics: A Structural Econometric Analysis.
Journal of Monetary Economics 44(2), 195222.
Gali, J., J. D. Lopez-Salido, and J. Valles (2004). Understanding the Effects of
Government Spending on Consumption. International Finance Discussion Papers. No. 805.
Henriksson, M. (2005). Productivity Differentials and External Balance in ERM II. Bank
of Finland Research Discussion Papers. No. 7.
Holmsberg, K. (2006). Derivation and Estimation of a New Keynesian Phillips Curve in
a Small Open Economy. Sveriges Riksbank Working Paper Series. No. 197.
Lendvai, J. (2005). Hungarian Inflation Dynamics. Central Bank of Hungary Occasional
Papers. No. 46.
Miller, J. (1999). The Currency Board in Bulgaria: The First Two Years. National Bank
of Bulgaria Discussion Papers. No. 11.
Natalucci, F. and F. Ravenna (2003). The Road to Adopting the Euro: Monetary Policy
and Exchange Rate Regimes in EU Candidate Countries. International Finance Discussion
Papers. Board of Governors of the Federal Reserve System, No. 741.
Nenovsky, N. and K. Hristov (2002). The New Currency Boards and Discretion:
Empirical Evidence from Bulgaria. Economic Systems 26 (1), 5572.
Sorsa, P. (2002). The Currency Board is Likely to Continue to Serve Bulgaria Well.
Note of the IMF representative to Bulgaria presented to the Economist Conference on
Bulgaria, March 6, 2002.
Valev, H. (2005). General Equilibrium View on the Trade Balance Dynamics in
Bulgaria. National Bank of Bulgaria Discussion Papers. No. 52.
33
D
I
S
C
U
S
S
I
O
N

P
A
P
E
R
S
DP/1/1998 The First Year of the Currency Board in Bulgaria
Victor Yotzov, Nikolay Nenovsky, Kalin Hristov, Iva Petrova, Boris Petrov
DP/2/1998 Financial Repression and Credit Rationing under Currency Board
Arrangement for Bulgaria
Nikolay Nenovsky, Kalin Hristov
DP/3/1999 Investment Incentives in Bulgaria: Assessment of the Net Tax Effect on
the State Budget
Dobrislav Dobrev, Boyko Tzenov, Peter Dobrev, John Ayerst
DP/4/1999 Two Approaches to Fixed Exchange Rate Crises
Nikolay Nenovsky, Kalin Hristov, Boris Petrov
DP/5/1999 Monetary Sector Modeling in Bulgaria, 19131945
Nikolay Nenovsky, Boris Petrov
DP/6/1999 The Role of a Currency Board in Financial Crises: The Case of Bulgaria
Roumen Avramov
DP/7/1999 The Bulgarian Financial Crisis of 19961997
Zdravko Balyozov
DP/8/1999 The Economic Philosophy of Friedrich Hayek
(The Centenary of his Birth)
Nikolay Nenovsky
DP/9/1999 The Currency Board in Bulgaria: Design. Peculiarities
and Management of Foreign Exchange Cover
Dobrislav Dobrev
DP/10/1999 Monetary Regimes and the Real Economy (Empirical Tests before and
after the Introduction of the Currency Board in Bulgaria)
Nikolay Nenovsky, Kalin Hristov
DP/11/1999 The Currency Board in Bulgaria: The First Two Years
Jeffrey B. Miller
DP/12/1999 Fundamentals in Bulgarian Brady Bonds: Price Dynamics
Nina Budina, Tsvetan Manchev
DP/13/1999 Currency Circulation after Currency Board Introduction in Bulgaria
(Transactions Demand, Hoarding, Shadow Economy)
Nikolay Nenovsky, Kalin Hristov
DP/14/2000 Macroeconomic Models of the International Monetary Fund and the
World Bank (Analysis of Theoretical Approaches and Evaluation of Their
Effective Implementation in Bulgaria)
Victor Yotzov
DP/15/2000 Bank Reserve Dynamics under Currency Board Arrangement for Bulgaria
Boris Petrov
DP/16/2000 A Possible Approach to Simulate Macroeconomic Development of
Bulgaria
Victor Yotzov
DISCUSSION PAPERS
34
D
P
/
6
0
/
2
0
0
7
DP/17/2001 Banking Supervision on Consolidated Basis (in Bulgarian only)
Margarita Prandzheva
DP/18/2001 Real Wage Rigidity and the Monetary Regime Choice
Nikolay Nenovsky, Darina Koleva
DP/19/2001 The Financial System in the Bulgarian Economy
Jeffrey Miller, Stefan Petranov
DP/20/2002 Forecasting Inflation via Electronic Markets Results
from a Prototype Experiment
Michael Berlemann
DP/21/2002 Corporate Image of Commercial Banks (19961997) (in Bulgarian only)
Miroslav Nedelchev
DP/22/2002 Fundamental Equilibrium Exchange Rates and Currency Boards: Evidence
from Argentina and Estonia in the 90s
Kalin Hristov
DP/23/2002 Credit Activity of Commercial Banks and Rationing in the Credit Market
in Bulgaria (in Bulgarian only)
Kalin Hristov, Mihail Mihailov
DP/24/2001 Balassa Samuelson Effect in Bulgaria (in Bulgarian only)
Georgi Choukalev
DP/25/2002 Money and Monetary Obligations: Nature, Stipulation, Fulfilment
Stanislav Natsev, Nachko Staykov, Filko Rosov
DP/26/2002 Regarding the Unilateral Euroization of Bulgaria
Ivan Kostov, Jana Kostova
DP/27/2002 Shadowing the Euro: Bulgarias Monetary Policy Five Years on
Martin Zaimov, Kalin Hristov
DP/28/2002 Improving Monetary Theory in Post-communist Countries Looking Back
to Cantillon
Nikolay Nenovsky
DP/29/2003 Dual Inflation under the Currency Board: The Challenges of Bulgarian EU
Accession (in Bulgarian only)
Nikolay Nenovsky, Kalina Dimitrova
DP/30/2003 Exchange Rate Arrangements, Economic Policy and Inflation: Empirical
Evidence for Latin America
Andreas Freytag
DP/31/2003 Inflation and the Bulgarian Currency Board
Stacie Beck, Jeffrey B. Miller, Mohsen Saad
DP/32/2003 Banks Firms Nexus under the Currency Board: Empirical Evidence from
Bulgaria
Nikolay Nenovsky, Evgeni Peev, Todor Yalamov
DP/33/2003 Modelling Inflation in Bulgaria: Markup Model (in Bulgarian only)
Kalin Hristov, Mihail Mihailov
35
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DP/34/2003 Competitiveness of the Bulgarian Economy
Konstantin Pashev
DP/35/2003 Exploring the Currency Board Mechanics: a Basic Formal Model
Jean-Baptiste Desquilbet, Nikolay Nenovsky
DP/36/2003 A Composite Tendency Indicator for Bulgarias Industry
(in Bulgarian only)
Tsvetan Tsalinsky
DP/37/2003 The Demand for Euro Cash: A Theoretical Model and Monetary Policy
Implications
Franz Seitz
DP/38/2004 Credibility Level of the Bulgarian Exchange Rate Regime, 19912003:
First Attempt at Calibration (in Bulgarian only)
Georgi Ganev
DP/39/2004 Credibility and Adjustment: Gold Standards Versus Currency Boards
Jean-Baptiste Desquilbet, Nikolay Nenovsky
DP/40/2004 The Currency Board: The only game in town (in Bulgarian only)
Kalin Hristov
DP/41/2004 The Relationship between Real Convergence and the Real Exchange
Rate: the Case of Bulgaria
Mariella Nenova
DP/42/2004 Effective Taxation of Labor, Capital and Consumption in Bulgaria
Plamen Kaloyanchev
DP/43/2004 The 1911 Balance of Payments of the Kingdom of Bulgaria
(in Bulgarian only)
Martin Ivanov
DP/44/2004 Beliefs about Exchange-rate Stability: Survey Evidence from the Currency
Board in Bulgaria
Neven T. Valev, John A. Carlson
DP/45/2004 Opportunities of Designing and Using the Money Circulation Balance (in
Bulgarian only)
Metodi Hristov
DP/46/2005 The Microeconomic Impact of Financial Crises: The Case of Bulgaria
Jonathon Adams-Kane, Jamus Jerome Lim
DP/47/2005 Interest Rate Spreads of Commercial Banks in Bulgaria (in Bulgarian only)
Michail Michailov
DP/48/2005 Total Factor Productivity Measurement: Accounting and Economic
Growth in Bulgaria (in Bulgarian only)
Kaloyan Ganev
DP/49/2005 An Attempt for Measurement of Core Inflation in Bulgaria
(in Bulgarian only)
Kalina Dimitrova
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7
DP/50/2005 Economic and Monetary Union on the Horizon
Dr Tsvetan Manchev, Mincho Karavastev
DP/51/2005 The Brady Story of Bulgaria (in Bulgarian only)
Garabed Minassian
DP/52/2006 General Equilibrium View on the Trade Balance Dynamics in Bulgaria
Hristo Valev
DP/53/2006 The Balkan Railways, International Capital and Banking from the End of
the 19th Century until the Outbreak of the First World War
Peter Hertner
DP/54/2006 Bulgarian National Income between 1892 and 1924
Martin Ivanov
DP/55/2006 The Role of Securities Investor Compensation Schemes for the
Development of the Capital Market (in Bulgarian only)
Mileti Mladenov, Irina Kazandzhieva
DP/56/2006 The Optimal Monetary Policy under Conditions of Indefiniteness
(in Bulgarian only)
Nedyalka Dimitrova
DP/57/2007 Two Approaches to Estimating the Potential Output of Bulgaria
Tsvetan Tsalinski
DP/58/2007 Informal Sources of Credit and the Soft Information Market
(Evidence from Sofia)
Luc Tardieu
DP/59/2007 Do Common Currencies Reduce Exchange Rate Pass-through?
Implications for Bulgaria's Currency Board
Slavi T. Slavov