Foreign Exchange, Prices and Economic Activity in Bulgaria

Bulgaria, like other socialist economies in transition, is attempting to implement an ambitious programme which combines a price reform to reduce price distortions and to liberalize pricing mechanisms, with macroeconomic stabilization to reduce the budget deficit and lower the underlying rate of inflation. The paper develops an input-output model to investigate the relationship between the exchange rate and the domestic price level. It shows that the success of the reform programme is closely linked to the path followed by the exchange rate. The government's stated policy is that it will not attempt to control the level of the exchange rate. The simulations suggest, however, that the government should use the exchange rate as the real anchor for the reform programme that is, by targeting a level for the real exchange rate rather than the nominal exchange rate. Under such a policy it will be able to implement the necessary adjustments to controlled prices for food and energy without re-initiating the inflationary spiral that began in 1990.