Discussion Paper DP/2007/60

7/30/2019 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: [email protected]: 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: [email protected]


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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

Documents

Discussion Paper DP/2007/60