Macroeconomic Issues In A Small Transition Economy: The Case of Latvia.

Abstract

In a series of essays a number of important issues of macroeconomic modelling of a small transition economy are explored. The essays are unified by the common theme of dollarization or currency substitution, which is asserted to be a significant characteristic of many transition economies. Two introductory chapters survey firstly, economic development in transition and secondly the phenomenon of currency substitution. These are followed by the construction of an integrated stochastic macroeconomic model of a transition economy at the early stage of reform, which employs a general equilibrium optimizing framework. The main issues addressed are: domestic money demand, the currency substitution ratio, the expected rate of inflation, real assets returns, the equilibrium growth rate of economy as well as government ability to control these variables. An expression for the currency substitution ratio is derived from the 'first principles' of stochastic optimization. Next is a comprehensive econometric analysis of currency substitution in Latvia. This is among the first research of this kind. Rather than drawing inferences on the degree of currency substitution from domestic money demand modelling, the most common approach to the empirical analysis of the phenomenon, the chapter employs direct modelling of the currency substitution ratio. Extensive model construction, estimation, evaluation and testing are perforined with the use of wide range of modem econometric techniques. Methodological issues are exposed and discussed. A number of instruments are identified, which can be used by the monetary authorities to influence currency substitution behaviour. Finally, the impact of an unanticipated monetary shock in a small open transition economy with dollarization, factor price rigidities, and nontradeables is reexamined. This chapter represents a first time, non-trivial expansion of the recent socalled 'new open economy macroeconomics' to account for the dollarization phenomenon which has been a persistent feature of many transition economies. Among other findings, it is interesting to note the stabilizing role of economic openness.