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

Listed author(s):
  • Ali M. Kutan
  • Josef C. Brada

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.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1998-021.

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Date of creation: 1998
Publication status: Published in Prague Economic Papers, December 1999
Handle: RePEc:fip:fedlwp:1998-021
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  1. 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.
  2. Lionel Halpern & Charles Wyplosz, 1996. "Equilibrium Exchange Rates in Transition Economies," IMF Working Papers 96/125, .
  3. Josef Jílek & Jiřina Jílková, 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, January.
  4. Frederic S. Mishkin & Adam S. Posen, 1998. "Inflation Targeting: Lessons from Four Countries," NBER Working Papers 6126, National Bureau of Economic Research, Inc.
  5. 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.
  6. Anthony J. Richards & Gunnar Tersman, 1995. "Growth, Nontradables, and Price Convergence in the Baltics," IMF Working Papers 95/45, .
  7. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  8. 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, M.E. Sharpe, Inc., vol. 36(1), pages 66-81, February.
  9. Begg, David, 1998. "Pegging Out: Lessons from the Czech Exchange Rate Crisis," CEPR Discussion Papers 1956, C.E.P.R. Discussion Papers.
  10. 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.
  11. 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.
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