Monday, May 21, 2007

Inflation in Latvia

Inflation has become one of main political issues in Latvia. Year-to-year increase of consumer price index is now at 8.8%, highest in the European Union. Introduction of euro has been postponed indefinitely. Bank of Latvia has raised its interest rates and the parliament has passed an anti-inflation package of tax changes and other measures.

I suspect the effect of those measures will be quite limited and not because the Latvian government does not want lower inflation. In 1960s, Canadian economist Robert Mundell came up with an economic model of small open economies, for which (together with other achievements) he would win Nobel Prize in Economics in 1999. A consequence of Mundell's work is that a country cannot simulteneously have the following three things (known as "Impossible trinity"):

Canada (Mundell's homeland) has capital moving freely between it and United States (in 1960s) and it and the rest of world (now) but the exchange rate between Canadian and US dollar is not fixed. It has fluctuated widely, from 65 Canadian cents for one US dollars to 90 Canadian cents for one US dollar, in just last 5 years. As a result, the Bank of Canada is able to set its monetary policy independently of United States.

Latvia has made a different choice. The money is moving freely between it and the rest of EU and beyond and the exchange rate between the Latvian lat and the euro is fixed. That's the first and the second of three conditions of Mundell's "impossible trinity". So, we can't have the third.

Latvia's monetary policy is effectively in hands of European Central Bank, instead of Latvian authorities. Bank of Latvia can change the interest rates for loans in lats, but if those get to high, everyone will start borrowing in euros. (That is, everyone who is not already borrowing in euros...) And if the current policies of European Central Bank result in high inflation in Latvia, there's not much Latvia can do... It's not a satisfying answer but I'm afraid it's true...

1 comment:

David Wozney said...

A “Federal Reserve Note” is not a U.S.A. dollar. In 1973, Public Law 93-110 defined the U.S.A. dollar as consisting of 1/42.2222 fine troy ounces of gold.