Comments on “Should the CNB devalue the exchange rate?” by Tkalec and Vizek

Kenichi UedaInternational Monetary Fund

Young Economists Seminar,Dubrovnik, June 23, 2010

The views expressed in this paper are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board or its management.

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Summary of the PaperSummary of the Paper

The paper investigates whether and how PPP hypothesis holds in HRK/EUR. Thoroughly investigated the issue using “error correction” framework. PPP holds in the long run. In the short run, ex rate appears to adjust given exogenous

domestic and EMU price levels.

Authors conclude that it is the domestic price level that needs to adjust. Then, PPP will hold. And thus, the current “managed float” does not need to be

changed.

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Comment 1: Deaton Critique (meas error)Comment 1: Deaton Critique (meas error)Different consumption basket across

countries made PPP study difficult.Are Croatia’s and EMU’s goods the same?

If not, PPP is not perfectly measured. If yes, it may be the case that some goods are “too

exotic” (and thus “high” price) in Croatia/other country.

As an economy rapidly grows, consumption basket changes. Additional difficulties to compare PPP between

advanced and transition economies.

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Comment 2: Lucas Critique (endogeneity)Comment 2: Lucas Critique (endogeneity)To adjust the price level, it is inevitable to start

with lowering public sector wages as well as to shrink the public sector.

The large adjustments or “change in price” is likely to correct the short-run error from the PPP.

So, after the adjustment, the regression results could reverse.

Need to think about theory, too.

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Comment 3: A deeper question: best policyComment 3: A deeper question: best policyDifficult trade-offs, but manageable

Competitiveness better to devalue ex rateEuro denominated debt better to keep ex valueHowever, rigid labor and product markets due to

large presence of government can be improved. Lower wages can improve competitiveness although they

would make people difficult to repay debts. But, this potential NPL problem can be mitigated by

higher and more steady growth, which can be brought by more flexible labor and product markets (more on this).