Inflation and growth in the transition from socialism : the case of Bulgaria

Bulgaria's shaky macroeconomic situation is a serious obstacle for a smooth transition from central planning to markets. It has to correct large current account deficits with the convertible currencyarea. It has to eliminate inflationary pressures and large price distortions, and get into a path of sustainable growth. The links between inflation, money velocity, the money overhang, and the fiscal deficit are crucial for assessing probable inflationary trends in Bulgaria. The author shows that with controlled prices and financial repression, low velocity keeps inflation at an artificially low level despite large fiscal deficits. But as prices are deregulated and the financial sector is reformed, velocity can be expected to increase. Bulgaria's moves toward a market economy are likely to affect growth through several channels. Reforms of the incentive structure will make part of the capital stock economically obsolete, hampering productive capacity in the short run. The response of private investment to the new incentives will be highly sensitive to macroeconomic stability and the perceived probability that the reform process will last and consolidate. Given these impediments, external support in the form of new financing and direct investment will play a major role in consolidating the reform and in the resumption of growth.