discussion paper dp/2007/60
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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
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The Bulgarian Economy on Its Wayto the EMU: Economic Policy Results
from a Small-scale Dynamic Stochastic
General Equilibrium Framework
Jochen Blessing
June 2007
BULGARIAN
NATIONAL
BANK
DISCUSSION PAPERSDISCUSSION PAPERSDP/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.orgWebsite: 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 .............................................. 133.4 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 smallopen 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 tradablesremains constant.
Policy simulations are used to investigate the impact of changes in the economic environment towhich transition economies and Bulgaria in particular are currently exposed to. We explore the effectsof a Balassa-Samuelson (BS) type shock for sectoral and overall inflation and discuss current accountsustainability and implications for the internal real exchange rate. We find that under the currencyboard the BS effect is not as persistent as found for accession countries under a fixed exchange rate inrelated 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 thecurrent account. Fiscal policies under the currency board put upward pressures on the sector-specificinflation 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 issolved using Uhligs toolkit.
* This paper was written during a research stay at the Bulgarian National Bank in July and August2006. 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, Departmentof Economics, Freie Universitat Berlin, e-mail: jochen.blessing@web.de
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References
Benigno, G. and C. Thoenissen (2003). Equilibrium Exchange Rates and Supply-side
Performance. The Economic Journal113 (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 DavidsonInstitute Working Papers Series. No. 2004710.
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 ina 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.
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DP/1/1998 The First Year of the Currency Board in BulgariaVictor Yotzov, Nikolay Nenovsky, Kalin Hristov, Iva Petrova, Boris Petrov
DP/2/1998 Financial Repression and Credit Rationing under Currency BoardArrangement for BulgariaNikolay Nenovsky, Kalin Hristov
DP/3/1999 Investment Incentives in Bulgaria: Assessment of the Net Tax Effect onthe State BudgetDobrislav Dobrev, Boyko Tzenov, Peter Dobrev, John Ayerst
DP/4/1999 Two Approaches to Fixed Exchange Rate CrisesNikolay Nenovsky, Kalin Hristov, Boris Petrov
DP/5/1999 Monetary Sector Modeling in Bulgaria, 19131945Nikolay Nenovsky, Boris Petrov
DP/6/1999 The Role of a Currency Board in Financial Crises: The Case of BulgariaRoumen Avramov
DP/7/1999 The Bulgarian Financial Crisis of 19961997Zdravko 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. Peculiaritiesand Management of Foreign Exchange Cover
Dobrislav DobrevDP/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 YearsJeffrey B. Miller
DP/12/1999 Fundamentals in Bulgarian Brady Bonds: Price DynamicsNina 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 theWorld Bank (Analysis of Theoretical Approaches and Evaluation of TheirEffective Implementation in Bulgaria)Victor Yotzov
DP/15/2000 Bank Reserve Dynamics under Currency Board Arrangement for BulgariaBoris Petrov
DP/16/2000 A Possible Approach to Simulate Macroeconomic Development ofBulgaria
Victor Yotzov
DISCUSSION PAPERS
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DP/17/2001 Banking Supervision on Consolidated Basis (in Bulgarian only)Margarita Prandzheva
DP/18/2001 Real Wage Rigidity and the Monetary Regime ChoiceNikolay Nenovsky, Darina Koleva
DP/19/2001 The Financial System in the Bulgarian EconomyJeffrey Miller, Stefan Petranov
DP/20/2002 Forecasting Inflation via Electronic Markets Resultsfrom a Prototype ExperimentMichael 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: Evidencefrom Argentina and Estonia in the 90sKalin Hristov
DP/23/2002 Credit Activity of Commercial Banks and Rationing in the Credit Marketin 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, FulfilmentStanislav Natsev, Nachko Staykov, Filko Rosov
DP/26/2002 Regarding the Unilateral Euroization of BulgariaIvan Kostov, Jana Kostova
DP/27/2002 Shadowing the Euro: Bulgarias Monetary Policy Five Years onMartin Zaimov, Kalin Hristov
DP/28/2002 Improving Monetary Theory in Post-communist Countries Looking Backto CantillonNikolay Nenovsky
DP/29/2003 Dual Inflation under the Currency Board: The Challenges of Bulgarian EUAccession (in Bulgarian only)Nikolay Nenovsky, Kalina Dimitrova
DP/30/2003 Exchange Rate Arrangements, Economic Policy and Inflation: Empirical
Evidence for Latin AmericaAndreas Freytag
DP/31/2003 Inflation and the Bulgarian Currency BoardStacie Beck, Jeffrey B. Miller, Mohsen Saad
DP/32/2003 Banks Firms Nexus under the Currency Board: Empirical Evidence fromBulgariaNikolay Nenovsky, Evgeni Peev, Todor Yalamov
DP/33/2003 Modelling Inflation in Bulgaria: Markup Model (in Bulgarian only)Kalin Hristov, Mihail Mihailov
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DP/34/2003 Competitiveness of the Bulgarian EconomyKonstantin Pashev
DP/35/2003 Exploring the Currency Board Mechanics: a Basic Formal ModelJean-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 PolicyImplicationsFranz 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 BoardsJean-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 ExchangeRate: the Case of BulgariaMariella Nenova
DP/42/2004 Effective Taxation of Labor, Capital and Consumption in BulgariaPlamen 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 CurrencyBoard in BulgariaNeven T. Valev, John A. Carlson
DP/45/2004 Opportunities of Designing and Using the Money Circulation Balance (inBulgarian 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 EconomicGrowth 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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DP/50/2005 Economic and Monetary Union on the HorizonDr 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 BulgariaHristo Valev
DP/53/2006 The Balkan Railways, International Capital and Banking from the End ofthe 19th Century until the Outbreak of the First World WarPeter Hertner
DP/54/2006 Bulgarian National Income between 1892 and 1924Martin Ivanov
DP/55/2006 The Role of Securities Investor Compensation Schemes for theDevelopment 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 BulgariaTsvetan 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 BoardSlavi T. Slavov
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