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The persistence of moderate inflation in the Czech Republic and the Koruna crisis of May 1997

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  • Ali M. Kutan
  • Josef C. Brada

Abstract

Macroeconomic policy in the Czech Republic has been based on a fixed exchange rate for most of the post-1993 period and a conservative fiscal policy characterized by a government budget that was close to balance combined with a tight monetary policy that sought to maintain high interest rates and to restrict the growth of the money supply. Surprisingly, given the Czech Republic's good starting conditions for carrying out such a "soft landing" in its macroeconomic stabilization, the economy was hit by a speculative attack on the koruna in May, 1997, and the economy, which had shown some signs of an increasing tempo of growth, appears to have slid into recession. At the same time, inflation has proven to be, while moderate by regional standards, surprisingly resistant to dropping below 10% per annum, thus leaving the Czech Republic in an undesirable state of "stagflation". with output declining, unemployment rising, and inflation accelerating. In this paper we argue that, although the fixed nominal exchange rate policy may have been retained for too long, and that, while the mix of monetary and fiscal policies was inappropriate given the desire for a fixed nominal exchange rate, the key problem for Czech policy both before and after the abandonment of a fixed exchange rate policy was and is the persistence of a rate of inflation that exceeds that of its major trading partners by a large margin. After explaining the relationship between Czech inflation, exchange rate and macroeconomic policies and the crisis of May, 1997, we examine some explanations for the persistence of inflation in the Czech Republic at a level around 10%. We close by examining the policy implications of our findings in the context of the Czech National Bank's new policy of inflation targeting.

Suggested Citation

  • Ali M. Kutan & Josef C. Brada, 1998. "The persistence of moderate inflation in the Czech Republic and the Koruna crisis of May 1997," Working Papers 1998-021, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:1998-021
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    References listed on IDEAS

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    1. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
    2. László Halpern & Charles Wyplosz, 1997. "Equilibrium Exchange Rates in Transition Economies," IMF Staff Papers, Palgrave Macmillan, vol. 44(4), pages 430-461, December.
    3. Drabek, Zdenek & Brada, Josef C., 1998. "Exchange Rate Regimes and the Stability of Trade Policy in Transition Economies," Journal of Comparative Economics, Elsevier, vol. 26(4), pages 642-668, December.
    4. Josef Jílek & Jiřina Jílková & Liana Payson, 1998. "The Reaction of Residents and Nonresidents to the Widening of the Intervention Band of the Czech Koruna," Eastern European Economics, Taylor & Francis Journals, vol. 36(1), pages 66-81, February.
    5. Richards, Anthony J. & Tersman, Gunnar H. R., 1996. "Growth, Nontradables, and Price Convergence in the Baltics," Journal of Comparative Economics, Elsevier, vol. 23(2), pages 121-145, October.
    6. Brada, Josef C., 1998. "Introduction: Exchange Rates, Capital Flows, and Commercial Policies in Transition Economies," Journal of Comparative Economics, Elsevier, vol. 26(4), pages 613-620, December.
    7. Desai, Padma, 1998. "Macroeconomic Fragility and Exchange Rate Vulnerability: A Cautionary Record of Transition Economies," Journal of Comparative Economics, Elsevier, vol. 26(4), pages 621-641, December.
    8. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
    9. William J. McDonough, 1997. "A framework for the pursuit of price stability," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 1-7.
    10. Begg, David, 1998. "Pegging Out: Lessons from the Czech Exchange Rate Crisis," Journal of Comparative Economics, Elsevier, vol. 26(4), pages 669-690, December.
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    Citations

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    Cited by:

    1. Yu Hsing, 2004. "Impacts of Macroeconomic Policies on Output in the Czech Republic: An Application of Romer's IS-MP-IA Model," Prague Economic Papers, University of Economics, Prague, vol. 2004(4), pages 339-345.
    2. Orlowski, Lucjan T., 2001. "Monetary convergence of the EU candidates to the Euro: A theoretical framework and policy implications," ZEI Working Papers B 25-2001, University of Bonn, ZEI - Center for European Integration Studies.
    3. Orlowski, Lucjan T., 2002. "Monetary convergence and risk premiums in the EU candidate countries," ZEI Working Papers B 26-2002, University of Bonn, ZEI - Center for European Integration Studies.
    4. Orlowski, Lucjan T., 2005. "Monetary convergence of the EU accession countries to the eurozone: A theoretical framework and policy implications," Journal of Banking & Finance, Elsevier, vol. 29(1), pages 203-225, January.
    5. Lucjan T Orlowski, 2005. "Monetary Policy Adjustments on the Final Passage towards the Euro," Macroeconomics 0503022, EconWPA.

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    Keywords

    Money ; Czech Republic ; Inflation (Finance);

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