Achieving Low Inflation in Transition Economies. The Role of Relative Price Adjustment

• Author: Sharmini Coorey/Mauro Mecagni/Erik Offerdal
• Position: Assistant to the Director of the IMF's Asia and Pacific Department/IMF's Resident Representative in Egypt/IMF's Resident Representative in Vietnam
• Pages: 30-33

Many transition economies have been unable to reduce inflation to low levels on a sustained basis. Monetary growth has been a dominant factor. Relative price adjustment and nominal wage shocks are also partly to blame, but their impact on inflation can be modified by monetary and exchange rate policy.

Page 30

MANY TRANSITION economies have succeeded in reducing very high inflation rates to 15-30 percent annually. But few have succeeded in achieving inflation rates below 10 percent on a sustained basis. Are loose financial policies and strong wage pressures-the usual culprits-fueling inflation in the transition countries, or are there forces peculiar to these economies that make it difficult to bring inflation rates down rapidly? Is the ongoing adjustment of relative prices-a necessary process in the transition economies-responsible for the failure to achieve and sustain low inflation rates?

If relative price adjustments are an important factor, reducing inflation to low levels in these countries may be associated with some cost in terms of growth. In countries where relative price shocks are significant, a rapid reduction in inflation is likely to bring about a greater output loss if economic agents whose prices have not increased resist or face costs in adjusting their own prices. When prices are "sticky," their downward adjustment normally occurs through unemployment and recession or, in fast-growing economies, through a temporary slowdown in growth. Since structural transformation is associated with large relative price shocks that may make disinflation costly in the short term, transition countries need to take care that attempts to meet low inflation targets do not result in delays to structural reforms. If structural reforms are postponed, any reduction in inflation is likely to be short- lived, as economic pressures will inevitably spill over and lead to renewed bouts of inflation. (For example, keeping prices for public services artificially low may require unsustainable fiscal subsidies that create inflationary pressures.)

What is the link?

According to classical economic theory, changes in relative prices are caused by real shocks and should not necessarily lead to an overall increase in the price level-that is, inflation. Nevertheless, a link between inflation and the variation of relative prices has been observed in the market economies since the 1920s. Measuring relative price variability in an objective and consistent manner across countries is not a simple task, however, not least because of the lack of comparable data. The literature defines the relative price change of a good in relation to an aggregate price index such as the consumer price index (CPI). For instance, if the inflation rate for bread exceeds the overall inflation rate of the CPI, the relative price of bread can be said to have increased.

It follows that large relative price shifts would result in a greater dispersion of the inflation rates of individual goods or services ("commodities") around the inflation rate of the overall index-that is, an increase in the variance of the inflation rates for individual commodities (Diagram 1). A country that liberalizes prices and undertakes substantial structural reform can be expected to have a greater variance in the distribution of its commodity inflation rates than a fully liberalized country or one that undertakes no reform. The question of whether relative price adjustment is associated with overall inflation can then be analyzed empirically in terms of whether changes in the variance of individual commodity inflation rates are systematically related to shifts in the inflation rate of the CPI (Diagram 2).

Variance is not the whole story, however. Recent literature on the subject suggests that if relative price shocks cause inflation -rather than the reverse-then one should observe a distribution of commodity Page 31 inflation rates that is skewed in a positive direction (Diagram 3). This is because an increase in variance alone need not cause inflation to accelerate if increases in the prices of some goods are matched by declines in the prices of others. However, if price adjustment is sticky-either because producers and wage earners resist lowering their prices or because there are costs to...