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Stagflation in Latvia: how long, how far, how deep?

  • Alf Vanags

    ()

    (Baltic International Centre for Economic Policy Studies (BICEPS))

  • Morten Hansen

    ()

    (Stockholm School of Economics in Riga (SSE Riga))

This policy paper assesses Latvian inflation performance in an EU and Baltic states context and speculates on the overall prospects for the Latvian economy in the light of the emerging slowdown both in Latvia and elsewhere. On inflation it is likely that, in the absence of new major price shocks, the May 2008 figure represents the peak of the current inflation episode – the slowdown of the economy and thus the unwinding of the overheated labour market should ensure this. On the pace of disinflation, evidence from a simple Phillips curve analysis, together with the flexibility of the Latvian labour market, points in the direction of a fast disinflation, while evidence from other countries emphasises the persistence of inflation. However, the Phillips curve analysis also predicts that lower inflation will come at the cost of higher unemployment. Using two alternative decompositions of inflation the paper examines the balance between a common inflation component and country specific inflation for Latvia and the Baltic states as against the EU-27 and the EU new member states. We find that, irrespective of method used, Latvia has much the biggest domestic inflation component of the three Baltic states. A much more overheated labour market in Latvia and perhaps belated policy response are to blame for the worse performance in Latvia. On duration and depth of a recession in Latvia we use evidence from international experience which suggests that the cumulative loss from a recession might be the equivalent of up to two years of double digit GDP growth relative to trend. Instead of growing 10-11% as was the norm until 2008 Latvia may experience negative growth of perhaps minus 1% for up to two years. This loss of potential GDP is a major setback for the prospects of Latvian convergence.

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Article provided by Baltic International Centre for Economic Policy Studies in its journal Baltic Journal of Economics.

Volume (Year): 8 (2008)
Issue (Month): 1 (October)
Pages: 5-28

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Handle: RePEc:bic:journl:v:8:y:2008:i:1:p:5-28
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  1. Marimon, Ramon & Zilibotti, Fabrizio, 1998. "'Actual' versus 'virtual' employment in Europe Is Spain different?," European Economic Review, Elsevier, vol. 42(1), pages 123-153, January.
  2. Olivier J. Blanchard & Jordi Galí, 2007. "The macroeconomic effects of oil price shocks: Why are the 2000s so different from the 1970s?," Economics Working Papers 1045, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2008.
  3. Frederic S. Mishkin, 2007. "Inflation Dynamics," International Finance, Wiley Blackwell, vol. 10(3), pages 317-334, December.
  4. Robin Brooks & Marco Del Negro, 2002. "The rise in comovement across national stock markets: market integration or IT bubble?," Working Paper 2002-17, Federal Reserve Bank of Atlanta.
  5. Stockman, Alan C., 1988. "Sectoral and national aggregate disturbances to industrial output in seven European countries," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 387-409.
  6. Alf Vanags & Morten Hansen, 2007. "Inflation in Latvia: causes, prospects and consequences," SSE Riga/BICEPS Occasional Papers 2, Baltic International Centre for Economic Policy Studies (BICEPS) and Stockholm School of Economics in Riga (SSE Riga).
  7. Laurence M. Ball, 2006. "Has Globalization Changed Inflation?," NBER Working Papers 12687, National Bureau of Economic Research, Inc.
  8. Blanchard, Olivier J & Galí, Jordi, 2008. "The Macroeconomic Effects of Oil Shocks: Why are the 2000s so Different from the 1970s?," CEPR Discussion Papers 6631, C.E.P.R. Discussion Papers.
  9. Ashoka Mody & Franziska Ohnsorge, 2007. "Can Domestic Policies Influence Inflation?," IMF Working Papers 07/257, International Monetary Fund.
  10. Alf Vanags & Morten Hansen, 2006. "Inflation in the Baltic States and Other EU New Member States: Similarities, Differences and Adoption of the Euro," SSE Riga/BICEPS Occasional Papers 1, Baltic International Centre for Economic Policy Studies (BICEPS) and Stockholm School of Economics in Riga (SSE Riga).
  11. Andrew Atkeson & Lee E. Ohanian., 2001. "Are Phillips curves useful for forecasting inflation?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-11.
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