Monetary accommodation in transition economies: econometric evidence from Yugoslavia's high inflation in the 1980s

Journal of Development Economics Vol. 62 Ž2000. 495–513 www.elsevier.comrlocatereconbase

Monetary accommodation in transition economies: econometric evidence from Yugoslavia’s high inflation in the 1980s Pavle Petrovic´ ) , Zorica Vujosevic ˇ ´ Faculty of Economics and CES Mecon, UniÕersity of Belgrade, Kamenicka ˇ 6, 11000 Belgrade, YugoslaÕia

Abstract A conjecture, advanced by some ad hoc evidence and the theory that money accommodates wage inflation in transition economies, is tested and accepted for Yugoslavia’s high inflation of the 1980s. Within a cointegration framework, an overidentified long-run structure is estimated and accepted, where money is cointegrated with wages while not with prices. Furthermore, two independent common stochastic trends emerge, suggesting that aggregate supply shocks Ži.e. those to wages and prices. and exchange rate shocks were driving Yugoslavia’s high inflation, while the impact of money supply shocks was transitory. These results are due to the presence of soft budget constraint where money passively validated wage and price decisions, and to the Yugoslav debt and balance of payments crises in the 1980s which triggered exchange rate shocks. The results on the role of aggregate supply shocks might bear general relevance for transition economies. q 2000 Elsevier Science B.V. All rights reserved. JEL classification: E31; E51; P27 Keywords: High inflation; Monetary accommodation; Transition economy; Cointegration; Stochastic trend

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Corresponding author. Tel.: q381-11-434-103; fax: q381-11-334-908. E-mail address: [email protected] ŽP. Petrovic´..

0304-3878r00r$ - see front matter q 2000 Elsevier Science B.V. All rights reserved. PII: S 0 3 0 4 - 3 8 7 8 Ž 0 0 . 0 0 0 9 4 - 8

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1. Introduction Monetary accommodation is fundamental in maintaining inflationary pressure both in market and transition economies, but the form it takes may differ in these two setups. Namely, there is a specific source of inflationary pressure in transition economies arising from the monetization of quasi-fiscal deficit. This deficit represents the losses of socially owned firms, which are substantial in transition economies with dominant social ownership. The losses occur since these firms do not comply with hard budget constraints; their monetization ultimately amounts to paying wages. Hence, a peculiar accommodation may emerge in transition economies, where money accommodates wage inflation instead of price inflation. A further implication is that transition economies might be particularly vulnerable to wage shocks. The above described phenomenon, if present, is interesting per se, but it also has important policy implications. In the short run, it suggests that wage policy is essential for controlling inflation in transition economies, while in the long run it points to the vital role of structural reforms aimed at hardening the budget constraint. A theory has been advanced ŽSahay and Vegh, 1995. explaining why in central planned economies, and in their transition to market economies, most of the money supply comes through higher wage bills, hence supporting the above conjecture. There is also some ad hoc evidence, as in Wolf Ž1993. who reports a correlation between wage growth and credit growth in enterprises in Russia. Sachs Ž1995. also reports that after the 1987 enterprise reform in Russia, enterprise wages rose sharply and firms started to rely more heavily on direct Central Bank credits. Early studies of the Yugoslav system suggest that the money supply might be largely endogenous, simply validating enterprise wage, price, and investment decisions ŽTyson, 1980.. Along that line of research, Chowdhury et al. Ž1990. found that money supply was endogenous with respect to output in the former Yugoslavia, contrary to the pattern observed in market economies. This paper has three objectives. The first is to thoroughly test whether the peculiar monetary accommodation of wages existed in the former Yugoslavia in the 1980s. The second is to explore what role, if any, wage and price shocks, i.e. soft budget constraint, played in driving Yugoslavia’s high inflation. The final objective is to explore whether the balance-of-payments view or the monetary view can add to the explanation of the high inflation in the 1980s. The case of Yugoslavia in the 1980s is relevant for current economies in transition since Yugoslavia had for quite some time a market economy with a dominant, socially owned sector and hence obeyed a soft budget constraint. Furthermore, Yugoslavia experienced high inflation throughout the 1980s, reaching hyperinflation in the last quarter of 1989. This high inflation provided an opportunity to test whether the specific monetary accommodation advanced above was present and to explore the relative importance of various shocks.

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Cointegration analysis was used to explore the first issue; in particular the identification of a long-run structure ŽJohansen and Juselius, 1994. and exogeneity testing within the latter ŽJohansen, 1988. were applied. The second and the third issues have been addressed by extracting the common stochastic trends ŽJohansen, 1995; Gonzalo and Granger, 1995. and by employing variance decomposition based on structural VAR. The paper is arranged as follows. In Section 2 some theoretical and ad hoc evidence on the relation between money and wages in transition economies is presented. Some facts are also noted on the institutional setup of the Yugoslav economy and its high inflation in the 1980s. Testing for unit roots and cointegration is used to identify the transmission mechanism in which money accommodates wages, and then to estimate short-run dynamics, i.e. error-correction models ŽECMs. for prices, wages, and money. In Section 4 the driving forces of the Yugoslav high inflation are explored by extracting common stochastic trends and by determining the relative importance of the exogenous shocks to each variable. Conclusions are given in Section 5.

2. A conceptual framework and ad hoc evidence Sahay and Vegh Ž1995. advanced a simple monetary model for planned economies implying that money printing automatically accommodates higher wages. Namely, in these economies the deficit to be financed by seigniorage belongs to the government-cum-enterprise sector. All firms are state-owned, and hence the government taxes away all profits and covers all losses. Therefore, when wages increase above their planned level, a deficit emerges in the governmentcum-enterprise sector and is then monetized.1 These firms, thereby, adhere to a soft budget constraint. As prices are controlled, the above monetization leads to repressed inflation and monetary overhang. Basically, the same model applies to transition economies with a dominant state sector. State-owned firms are not financially accountable, while bankruptcy is absent. Once released from central plan control, their main objective becomes

1

The budget constraint in the government-cum-enterprise sector is: Mq1 y M qPy sW qPg where resources, consisting of seigniorage Ž Mq1 y M . and output ŽPy. in the state sector, are on the left-hand side, and expenditures, that is wages ŽW . in the state sector and government consumption and investment ŽPg., on the right-hand side. The deficit, financed by money printing is then equal to: Mq1 y M s Pgy Ž PyyW . i.e. government consumption minus profits in the state sector. Hence, wage increase above the planned level directly leads to deficit and its monetization.

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wage maximization and employment protection. Once again, the relevant deficit belongs to the government-cum-state enterprise sector. Increases in wages, which are now more probable because a rigid central control has been removed, invoke the above deficit, and this leads to money printing necessary to cover this deficit. Thus Sachs Ž1995. reports that in Russia, after the 1987 enterprise reform, enterprise wages rose sharply and firms started to rely more heavily on direct Central Bank credits. Consequently, the money supply accommodated wages in transition economies as well. Important inflationary pressure again originated in the enterprise sector. Since in transition economies prices are liberalized, deficit monetization now leads to open inflation. Evidence on transition economies 2 suggests that, after having coped with monetary overhang and repressed inflation, the main inflationary pressure subsequently arises from the monetization of the quasi-fiscal deficit. Namely, the predominantly state-owned banking system is pressed by the government to extend highly subsidized loans to state enterprises. It is estimated that, among the slower reformers among transition economies,3 credit subsidies from central banks for covering the quasi-fiscal deficit were around three times larger then the fiscal deficit itself. In China, furthermore, where market reforms did not challenge the dominance of the state sector, large implicit subsidies to the enterprise sector, amounting to 3% to 4% of GDP, were recorded in the late 1980s and early 1990s. These subsidies came into existence through bank credits to enterprises and Central Bank credits to banks, both extended at negative real interest rates. The non-collected bad enterprise debts further increase the amount of the implicit subsidies mentioned above.4 A tentative transmission mechanism between money growth and inflation that is in line with the above has been advanced for Russia’s high inflation in the early 1990s. Namely, Wolf Ž1993. found a correlation between wage growth and lagged credit growth to the enterprise sector. Thus the increase in credit was used to finance demands for wage hikes in the enterprise sector. Subsequently, wage increases led to inflation through the cost-push mechanism. The former Yugoslavia, having introduced extensive market-based reforms as early as in the mid-1960s, yet retaining the dominant social sector, exhibited the main features of economies in transition for quite some time. Labor management was instituted, with firms maximizing the wage rate.5 As financial accountability was low, a constant increase in wages was hard to resist, thus putting strong

2

See World Development Report 1996: From Plan to Market, World Bank, 1996, 35–36. See World Development Report 1996 ŽWorld Bank, 1996, 36.. 4 See World Development Report 1996 ŽWorld Bank, 1996, 35.. 5 Strictly speaking, a labor-managed firm maximizes income per worker. For the theory see Vanek Ž1970., and for evidence on the Yugoslav system, e.g. Tyson Ž1980.. 3

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pressure on credit and, ultimately, the money supply. Therefore, one should expect to find a monetary accommodation of wages in the above setup. As suggested earlier, the fiscal deficit to look at in this institutional framework is the government-cum-socially owned enterprise sector. Narrowly defined public deficit, that excludes quasi-fiscal deficit, was practically absent in former Yugoslavia. The main pressure, however, came from the quasi-fiscal deficit, i.e. from losses of labor-managed firms, which dominated the enterprise sector in Yugoslavia. These firms were not state-owned but rather, loosely speaking, were controlled by the employees. Consequently, their losses were not explicitly covered by the state and therefore the losses did not add to the public deficit. However, the state exercised an informal pressure on the banking sector to finance these losses through the extension of soft loans to labor-managed firms. The loans were given at negative real interest rates, and most of them soon became non-performing. Subsequent high inflation in the 1980s sharply reduced the real value of these loans. The credits granted in the 1970s, when inflation was low, were mainly based on external borrowing and domestic savings held in foreign currency. These credits were, however, extended in domestic currency at the exchange rates prevailing at the time. In the 1980s, when the debt crisis broke out and inflation surged, large nominal currency depreciation wiped out enterprises’ dinar debts, ultimately leaving foreign currency liabilities in the hands of the Central Bank and the government. These losses formed the dominant part of the quasi-fiscal deficit in the 1980s.6 When external borrowing ceased in the early 1980s, the government mainly resorted to Central Bank crediting, while providing soft credits to the enterprise sector. As previously stated, early studies of the Yugoslav system suggest that the money supply might be largely endogenous, simply validating enterprise wage, price, and investment decisions ŽTyson, 1980.. Chowdhury et al. Ž1990. tested this conjecture by exploring the causality between money and economic activity in Yugoslavia, employing quarterly data from 1964 to 1986. They showed that in Yugoslavia the money supply was endogenous, hence merely adapting to exogenous movements in output, as opposed to the two market economies used as comparators. This finding agrees with our assumption that money supply accommodates wages. However, the wage accommodation hypothesis is more specific than the above endogeneity of money one. The former Yugoslavia experienced high inflation in the 1980s, which slowly built up through the mid-1980s and surged after 1987 from a 118% annual rate to as much as 1256% in 1989, reaching monthly rates of 50% in the last quarter of 1989 and thus, according to Cagan Ž1956., entering hyperinflation. A stabilization

6

See Lahiri Ž1991., Rocha Ž1991., and Petrovic´ Ž1995..

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package, launched on January 1, 1990, succeeded in halting high inflation in 3 months’ time and keeping it under control throughout the summer of 1990. Inflation again started to gain pace in 1991, and in July of the same year the war and the disintegration of the former Yugoslavia began. As seen from the above, in the 1980s and early 1990s the former Yugoslavia was exposed to a wide variety of inflationary experiences, ranging from slowbuilding inflation and its outburst into hyperinflation, to short-lived stabilization and a new resurgence of inflation. The institutional setup was a social but decentralized economy, that adhered to the soft budget constraint. Therefore, Yugoslavia of the 1980s and early 1990s provides a good opportunity to test the conjecture that in transition economies money accommodates wage inflation and that, consequently, transition economies are particularly sensitive to wage shocks. As to the causes of the Yugoslav high inflation in the 1980s, some preliminary results indicate the balance of payments explanation as opposed to the monetary view. Yugoslavia faced a debt crisis in the early 1980s, resulting in a switch from a considerable inflow of resources to their outflow. This called for both real devaluation and a decrease in real wages. The main impact occurred through 1984 when, in real terms, the exchange rate increased by approximately 70% while wages decreased by 25%. The enterprise sector did not adjust to large real devaluation, causing currency depreciation to put an upward pressure on wages and prices. Money then accommodated a nominal wage increase, while the wage growth initiated a wage-price spiral. Thus currency depreciation, enforced by the resulting wage and price shocks, was propelling the system, whereas the monetary accommodation of wages was a part of the transmission mechanism from exchange rate shocks to inflation. We shall now turn to a formal testing of the above hypotheses, i.e. both the monetary accommodation of wage inflation, and the role that supply and exchange rate shocks played in driving Yugoslavia’s high inflation.

3. Money accommodates wages 3.1. Identification of the long-run structure While testing the monetary accommodation of wages in Yugoslavia’s high inflation, we shall be identifying the long-run structure ŽJohansen and Juselius, 1994. among the relevant variables — exchange rate, wage rate, money supply, and price level. Specifically, we shall be looking for cointegration between these variables, expecting to find a vector which, upon identification, should reduce to a long-run relation between money and wages, thus determining money supply. Moreover, there should be one or two additional cointegration vectors that determine other variables. The cointegration analysis would then lay the founda-

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Table 1 Tests for unit roots The number of corrections is equal to 1 in all applied statistics. The critical value for the ADF and the PP tests, calculated from the regression with constant and trend is equal to y3.44 at the 5% significance level ŽMacKinnon, 1991.. Augmented Dickey–Fuller p

w

H0 : I Ž2. H1 : I Ž1. y3.12 y3.84 H0 : I Ž1. H1 : I Ž0. y1.62 y0.86 m– w

w– p

H0 : I Ž2. H1 : I Ž1. y6.17 a H0 : I Ž1. H1 : I Ž0. y3.22 y1.96 a

Phillips–Perron

ex y7.12 y0.54 ex– p

m

p

y6.61 y0.38

y3.34 y0.43

m– p a

y11.31 y1.12 a

m– w a

y5.56 y1.16 a

w

ex

y6.82 y0.69 w– p

y9.02 y2.82

ex– p a

y3.23

m

y7.08 y0.22

y13.10 y2.64 a

m– p a

y11.40 y1.16 a

y13.29 a y1.34 a

a Denotes the values obtained from the regression only with constant in which case the 5% critical value is equal to y2.89 ŽMacKinnon, 1991..

tion for determining short-run dynamics, i.e. estimating an ECM for each endogenous variable. Cointegration analysis, to which we now turn, will start with unit roots testing, and continue with testing the number of cointegration vectors. Restrictions on cointegration vectors will then be imposed and tested, along with weak exogeneity of the considered variables. Monthly series of the logarithms of retail prices Ž p ., exchange rate Žex., wage rate Ž w . and base money Ž m. are used, while the sample period runs from January 1980 to July 1991.7 The results of unit root testing, reported in Table 1, indicate that all these series were integrated of order one.8 Apart from the nominal series above, we also took a close look at their combinations, i.e. real exchange rate Žex–p ., real wage rate Ž w–p ., real base

7 The sources for the data are as follows. The retail price index and wages are taken from various issues of the Yugoslav Federal Statistical Office publication. The base money is taken from the National Bank of Yugoslavia Bulliten, various issues. When official exchange rates coincided with the market ones, they are taken from National Bank of Yugoslavia Bulliten; otherwise, the black market exchange rate are used, and they were collected by the authors from the black market and from daily newspapers. The black market exchange rate was, however, widely known and followed in the 1980s and early 1990s in Yugoslavia. 8 In fact, results on price level are inconclusive concerning the presence of the second unit root, as the value of the ADF test is below 5% Žy3.44. and 10% critical value Žy3.14., while the value of the PP test is under 5%, but above 10% critical value. However, upon closer inspection, we found that price level had one unit root and inflation was stationary with structural break.

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money Ž m–p . and money deflated by wages Ž m–w .. As seen from Table 1, the first three series are integrated of order one, while the last one is stationary. This implies that money did not cointegrate with prices, but with wages, as Ž m–p . is non-stationary and Ž m–w . is stationary.9 This preliminary result supports the previously advanced conjecture that money accommodates wages rather than inflation. The non-stationarity of real exchange rate Žex–p . indicates that nominal exchange rate and price levels were not cointegrated. This further implies that the exchange rate did not passively adapt to price movements, as the purchasing power parity hypothesis assumes, but rather followed a dynamic of its own. The above is in line with the balance of payments view which states that exchange rate dynamics plays a prominent role in triggering high inflation. In the same manner, the non-cointegration between wages and prices indicates that wages were not simply indexed to inflation in the 1980s. Wage growth lagged behind inflation through the mid-1980s, although wages followed price level dynamics more closely than exchange rates did. These results also show that prices are not set solely as a markup on either wages or the exchange rate, suggesting that one should actually try a combination of the two; this conjecture will be tested later on in this section. Having obtained the preliminary cointegration results, we now turn to a full-scale cointegration analysis and the identification of a long-run structure. While testing for cointegration between prices Ž p ., exchange rate Žex., wage rate Ž w . and base money Ž m., the Johansen Ž1988. procedure is used and the obtained results are reported in Table 2. The test statistic values obtained indicate the presence of two cointegrating vectors. The values of trace statistics 96.52 and 47.87, being greater than the 5% critical values Ž53.42 and 34.79, respectively., and 12.44 being lower than the 5% critical value Ž19.99., show that there are just two cointegrating vectors. The same result is also obtained with maximum eigenvalue test statistics. The estimates of the two cointegrating vectors, along with the adjustment coefficients, are given in Table 3. These two vectors are not uniquely determined in terms of stationarity, since any linear combination of the vectors is also stationary. For this reason, one needs other criteria to choose from the set of cointegrating relations, i.e. to identify the model. Johansen and Juselius Ž1994. showed that, for exact identification, the

9 Although the unit-root hypothesis for Ž m – w . is rejected only at 10% level Žy3.14., the Johansen test, however, gives the clear-cut result that m and w are cointegrated. Namely, the hypothesis of no cointegration is rejected at 5% level, as the value of the trace test obtained Ž21.81. is greater than the corresponding critical value Ž19.99.. The same test confirms the absence of cointegration between prices and money.

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Table 2 Testing cointegration among price level, wage rate, exchange rate, and base money Three dummy variables are included in VAR in order to improve its statistical properties: the first one takes the only non-zero value for November 1987 and captures the introduction of price, wage, and exchange rate controls; the second one, that has value 1 for June 1988 and 0 elsewhere, refers to their liberalization and subsequent outburst of inflation; the third one, having one non-zero value for February 1990, takes care of the structural break in inflation rate due to the stabilization package introduced in January 1990. Seasonal dummy variables are also included. A constant is restricted from entering the cointegration vector. There are eight lags in the VAR. The 5% critical values for the trace tests are as follows: 53.42 for r s 0, 34.79 for r F1, 19.99 for r F 2 and 9.13 for r F 3 ŽHansen and Juselius, 1995.. Rank

Eigenvalue

Trace test

r s0 r F1 r F2 r F3

0.310 0.237 0.074 0.018

96.52 47.87 12.44 2.32

number of restrictions on each vector should be equal to the number of cointegrating vectors minus one. As there are two cointegrating vectors, at least one restriction should be imposed on each vector. The relation between money and wages we are looking for could be given by the second cointegration vector Ž b 2 .. Therefore, we shall impose, and test, two zero restrictions which will eliminate prices and exchange rate from that vector.

Table 3 t-Values are given in parentheses, significant coefficients in bold; d stands for first difference, thus d p denotes inflation, etc. The cointegration vectors Variable

b1

b2

p w ex m Constant

1 y0.827 y0.273 0.058 y4.353

1 0.167 y0.295 y0.986 y1.579

The long-run adjustment coefficients Equation

a1

a2

dp dw dex dm

y0.310 Žy4.58. 0.475 Ž3.06. y0.095 Žy0.49. y0.687 Žy3.55.

y0.085 Žy2.388. 0.045 Ž0.545. y0.046 Žy0.451. 0.536 Ž5.255.

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The first cointegration vector Ž b 1 . seems to determine the long-run relation between prices, wages and exchange rate, implying one zero restriction that eliminates money. Furthermore, one may also set restrictions on the long-run adjustments coefficients. In particular, both a 31 and a 32 are not significantly different from zero Žcf. Table 3., implying that exchange rate might be weakly exogenous in the system. If so, exchange rate has been a driving force of the Yugoslav high inflation, thus supporting the balance of payments view. Thereby, we shall include and test these two restrictions Ž a 31 s a 32 s 0. as well. The restrictions above lead to an overidentified system and therefore they could be tested. The two cointegration vectors and corresponding long-run adjustment coefficients, estimated under the imposed restrictions, are presented in Table 4. The value of the corresponding chi-squareŽ3. statistics equals to 0.86Ž0.84. and shows that the null hypothesis, stating that the restrictions imposed are valid, cannot be refuted. Thus, the advanced long-run structure has been accepted, maintaining the existence of long-run relations between prices, wages, and exchange rate, and between money and wages. In addition, the weak exogeneity of exchange rate has been approved. The significance of the long-run adjustment coefficients a 11 and a 12 Žcf. Table 4. indicates that the first cointegrating vector enters the price Žd p . and wage Ždw . equations, implying that this vector determines both variables. Namely, short-run dynamics of both prices and wages adjusts to the long-run relation given by the first cointegrating vector. In the case of prices, this long-run relation can be interpreted as a mark up equation, thus confirming previously advanced conjecture that prices were indexed both to wages and exchange rate. Considering wages, the

Table 4 t-Values are given in parentheses and significant coefficients in bold Estimates under imposed restrictions, the cointegration vectors Variable

b1

b2

p w ex m Constant

1 y0.769 y0.278 0 y4.013

0 y0.933 0 1 y5.602

The long-run adjustment coefficients Equation

a1

a2

dp dw dex dm

y0.384 Žy5.00. 0.544 Ž3.10. 0 y0.155 Žy0.71.

0.06 Ž1.71. y0.037 Žy0.46. 0 y0.565 Žy5.66.

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long-run relation could exhibit a trade-off between real wages and real exchange rate. The second cointegration vector enters only the money equation Žd m., as only a 42 is significantly different from zero Žcf. Table 4.; this implies that money is endogenous and wages weakly exogenous. Therefore, money supply is determined by the second cointegration vector. 3.2. The short-run dynamics The determination of money growth Žd m., price inflation Žd p . and wage inflation Ždw ., discussed above, could be formally demonstrated by estimating corresponding ECMs. The estimated equations read as follows:

Note: t-values are given in parentheses. u1 denotes the cointegration vector of p, w and ex, while u2 denotes cointegration vector of m and w. Dummy variables stand for: Õ1 s 1 for June 1988 and 0 otherwise, due to liberalization of prices and exchange rate and subsequent outburst of inflation; Õ2 s 1 for January 1990 and 0 otherwise, due to the stabilization package aimed at halting high inflation. Significant seasonal dummy variables are also included. Since wages are endogenous with respect to prices, the first equation is estimated by the two-stage least squares Ždw ) is the reduced form estimates of dw .. s is the regression standard error. The reported test-statistics are: JBŽ2. — the Jarque–Bera test-statistic for normality of the residuals, that under the null of normality has chi2Ž2. distribution; AR1-7 — a Lagrange multiplier test-statistic for the seventh order autocorrelation

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in the residuals, which has approximately FŽ7,.. distribution; RESET — the regression specification test that tests the null of correct specification against the alternative that the residuals are correlated with the squared fitted values of the regressand with FŽ1,.. null distribution. J is the joint variance and regression coefficients instability test-statistic of Hansen Ž1992., indicating that the null hypothesis of coefficient stability cannot be refuted in either equation. The reported test-statistics do not indicate any misspecification in the estimated equations. As suggested by the cointegration analysis above, the first cointegration vector Ž u1. enters equations for price inflation Žd p . and wage inflation Ždw ., while the second vector Ž u2. enters the money growth Žd m. equation. Thus price and wage setting equations are obtained, indicating that these two variables adjust to long-run relation between prices, wages and exchange rate. Estimated ECM for money supply supports the result on peculiar monetary accommodation, i.e. besides adjusting to wages in the long-run, money growth Žd m. also depends on wage dynamics Ždw . in the short-run. Summarizing results in Section 3, we have identified the long-run structure that implies a peculiar transmission mechanism where money accommodates wage inflation instead of price inflation as it would be expected in market economies. This points to the special role that wages play in soft budget transition economies. We also determined that the nominal exchange rate, as opposed to money, was weakly exogenous in the identified long-run structure, hence suggesting that its shocks might have triggered the Yugoslavia’s high inflation in the 1980s. Finally, we found that the short-run dynamics of both prices and wages adjusts to long-run relation between prices, wages and exchange rate, while the dynamics of money supply adjusts to the relation between money and wages. This was confirmed by corresponding ECMs that were estimated.

4. Driving forces of Yugoslavia’s high inflation 4.1. Extraction of the common stochastic trends A foregoing analysis showed that exchange rate, being weakly exogenous in the system, was a driving force of Yugoslavia’s high inflation in the 1980s. We now turn to explore whether some additional forces governed Yugoslavia’s high inflation, i.e. what was the role of soft budget constraint and in particular wages. This issue can be addressed by extracting common factors or common stochastic trends. Common factors are linear combinations of variables that lend nonstationarity to the system and hence govern its long-run properties.10 Their 10

See Gonzalo and Granger Ž1995..

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Table 5 Common factors

a 1X H a 2X H

p

w

ex

m

0 1

0 0.71

1 0

0 0.05

determination is closely related to the above cointegration analysis: the two cointegration vectors obtained among four non-stationary variables imply that there are two Ž4 y 2. independent common factors. It follows that the long-run behavior of prices, wages, exchange rate, and money in the Yugoslav high inflation could be explained by only two distinct common factors. As exchange rate is the only weakly exogenous variable in the system, it represents one common factor, while the other common factor should be a linear combination of the variables. Upon estimation, the matrix of weights Ž a H . for the variables entering common stochastic factors shown in Table 5 was obtained.11 The two common factors then read as follows: Ž p, w, ex, m. a H . Thus, as previously explained, the first common factor is exchange rate Žex., while the second factor is the linear combination of prices and wages Ž p q 0.71w ., since the weight on money is practically zero. These factors could further be expressed as the sum of innovations in exchange rate Ž S eex . and the linear combination of the sum of innovations in prices and wages Ž S e p q 0.71S e w .. The first sum represents the stochastic trend of ex, and the second the stochastic trend that combines p and w.12 Consequently, non-stationarity of our four variables was due to accumulated unexpected shocks in exchange rate Ž S eex . and a linear combination of the shocks in prices Ž S e p . and wages Ž S e w .. Therefore, shocks to exchange rate, prices and wages had a permanent effect on all four variables. On the other hand, shocks in money supply had only a transitory effect on the considered variables. Exchange rate shocks, as explained in Section 2, could be related to balanceof-payment and debt crises that Yugoslavia faced in the 1980s, which caused frequent incidents of currency depreciation. The presence of these shocks in Yugoslavia’s high inflation and their permanent effect thus support the balanceof-payment explanation.

11

The weights a H are related to long-run adjustment coefficients a Žsee Table 4., so that a H ’ a s 0, i.e. a H is orthogonal complement to a . Estimation is done with CATS in RATS ŽHansen and Juselius, 1995.. 12 As VAR contains three intervention dummy variables and no constant entering unrestrictedly Žcf. Note to Table 2., the series considered do not have a deterministic trend. Permanent component thus consists of a stochastic trend and the accumulated effects of dummy variables Žcf. Johansen, 1995..

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Table 6 Loading factors Variable

b 1 H Žexchange rate shock.

b 2 H Žaggregate supply shock.

p w ex m

27.4 26.8 24.6 25.0

25.6 25.9 20.7 24.2

Shocks to prices and wages are aggregate supply shocks ensuing from the product and labor markets. These shocks could both be traced back to the soft budget environment. In this environment, wage claims and price increases to cover the losses were passively accommodated by the money supply. Thereby, the presence of aggregate supply shocks suggests that the soft budget constraint and the consequent quasi-fiscal deficit had contributed to Yugoslavia’s high inflation. Since accumulated shocks to money supply were stationary in the Yugoslav high inflation, they had only transitory impact on the variables. Consequently, money supply was governed by the innovations in the other three variables, while not having a permanent effect on any of them. This finding supports the statement that money simply validates enterprise wage and price decisions ŽTyson, 1980. as well as currency depreciation. The fiscal view, which states that inflation is due to monetization of the narrowly defined public deficit, which excludes quasi-fiscal deficit, obviously did not apply to Yugoslavia’s high inflation. Effects of the two stochastic trends on each variable are given by the matrix of loading factors b H , and the corresponding estimates are reported in Table 6.13 The first column shows the impacts of accumulated shocks to exchange rate on each variable, while the second column gives the corresponding impacts of aggregate supply shocks. It can be seen that the two stochastic trends have approximately the same relative importance in driving prices, wages, and money supply. However, as standard errors of b H estimates are unknown, the coefficients reported are only indicative.14 Therefore, we turn now to variance decomposition within VAR to further assess the relative importance of these shocks. 4.2. RelatiÕe impact of exogenous shocks While assessing the relative impact of exogenous shocks to each variable on the system, we shall further explore whether the Yugoslav high inflation arose due to 13

The matrix of loading factors b H represents an orthogonal complement of cointegration matrix b Žsee Table 4., i.e. b H ’ b s 0. Again CATS in RATS, Hansen and Juselius Ž1995. is used for estimation. 14 Juselius Ž1998..

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balance-of-payments crises and related exchange rate shocks, soft budget constraint accompanied by wage and price shocks, or monetization of fiscal deficit and triggered money supply shocks. The procedure to be used, while addressing the above issue, is variance decomposition within structural VAR. When the series are cointegrated, as they are in our case, one may estimate VAR either by using non-stationary I Ž1. variables or by employing stationary first differences and imposing cointegration restrictions. Ordinary least-squares estimates of the former have asymptotically normal distributions and are consistent ŽSims et al., 1990; Lutkepohl, 1991.. They have the same asymptotic properties as the maximum likelihood estimates of the latter that observe cointegration restrictions. Although the small sample properties may differ, we proceeded by using VAR in levels, as we had more than 100 observations. Once VAR is estimated, we have to specify contemporaneous relationships among variables in order to perform variance decompositions and calculate impulse response. One option is the Choleski factorization, which essentially imposes arbitrary ranking and relations among contemporaneous variables. The structural VAR approach, on the other hand, explicitly defines these relations in advance, but also raises some controversies. In Section 3 we have already identified a long-run structure among the current levels of the variables, which one can use for estimating structural VAR15 while adding the missing wage setting equation. Having done that, the following estimates of current relations among VAR residuals Ž rp, rw, rex, and rm. are obtained: rp s0.22 rwq0.09 rex Ž7.33 .

Ž2.25 .

rw s0.14 rex Ž1.40 .

rm s0.15 rw Ž1.67 .

Note: t-ratios are in parentheses. The coefficients obtained are all positive, as expected, and statistically significant, except the one in the wage setting equation which is significant only at 15%. The restrictions imposed on contemporaneous relations give an overidentified system, and one can thus test whether these restrictions hold. The corresponding value of chi-squareŽ2. test statistics is 2.59 Ž0.27., showing that the restrictions imposed cannot be refuted.

15

See also Dibooglu and Enders Ž1995..

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As the wage setting equation in the above structural VAR might not be significant, an alternative specification for wage and price setting equations is estimated, and the results read as follows: rp s0.11 rex Ž2.75 .

rw s1.23 rp Ž7.23 .

rm s0.15 rw Ž1.67 .

Note: t-ratios are in parentheses. All coefficients are now statistically significant, and also positive. Again, the imposed restrictions cannot be refuted since the corresponding value of chisquareŽ3. test statistics is 2.60Ž0.46.. Having estimated two alternative structural VARs, one can now use them to assess the relative importance of exogenous shocks to wages, prices, exchange rate, and money. Table 7 presents a decomposition of forecast error variance for these four variables, for 10- and 20-month forecasts, and for the two alternative structural VAR specifications. The two alternative specifications give the same results when impacts of the shocks to exchange rate and money supply are considered. The results show that the innovations in exchange rate had the strongest impact on the four variables. As depicted in Table 7, their impacts vary from 36% to 64%. On the other hand, money innovations practically have no impact upon the four variables, since their shares in the forecast error variances are only 1%. The relative importance of unexpected shocks in prices and wages differs considerably among the two specifications. This is not surprising since alternative

Table 7 Decomposition of forecast error variance Shocks in

10-month forecasts p

20-month forecasts

w

ex

m

p

w

ex

m

First specification, % p 2 w 68 ex 29 m 1

3 75 21 1

0 41 56 2

1 72 21 6

2 53 44 1

3 56 40 1

1 34 64 1

3 60 36 1

Second specification, % p 28 w 42 ex 29 m 1

34 43 21 1

14 28 56 2

27 46 22 5

25 30 44 1

28 31 40 1

14 21 64 1

30 33 36 1

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price and wage equations have been used. In the first case the impact of prices is negligible, while that of wages is dominant. In the second case, the importance of innovations in prices increases at the expense of wage innovations, although the latter still exercises the stronger impact on the system. We obtained the same results with the Choleski factorization and different orderings. Where prices are endogenous, the impact of prices is negligible while the impact of wages is dominant. However, with exogenous prices and endogenous wages, the impacts of the corresponding innovations are evenly distributed. Thus, whatever specification, the impact of aggregate supply shocks, i.e. both to wages and prices, played an important role in propagating the Yugoslav high inflation, emphasizing the role played by soft budget constraint and related quasi-fiscal deficit. The variance decomposition suggests that the impact of these shocks was somewhat stronger than that of exchange rate. Within aggregate supply shocks, innovations in wages seem to be dominant, showing the particular vulnerability of the economy to these shocks. The importance of exchange rate innovations in driving inflation indicates that high inflation is partly explained by the balance-of-payments view. The negligible impact of money supply concurs with the finding in Section 3 that money exercises only transitory effect on the other variables. Both the small impact and transitory effect show that monetization of narrowly defined fiscal deficit was not an issue in the Yugoslav high inflation.

5. Conclusions First, we have found a peculiar monetary accommodation in Yugoslavia’s high inflation in the 1980s, where the money supply accommodated wage inflation instead of price inflation. The identified relation between money and wages, as opposed to money and prices, is institutionally specific, i.e. it may emerge in an economy where the social sector and resulting soft budget constraint are dominant. The result obtained for Yugoslavia could therefore apply to transition economies in general. This finding suggests that monetary accommodation takes a different form in a transition economy than in a market economy. Specifically, upon unit roots and cointegration testing, two cointegrating vectors were obtained among price level, wage rate, exchange rate, and base money. Following the hypothesis advanced in the paper that money accommodates wages, an overidentified long-run structure was tested ŽJohansen and Juselius, 1994. and accepted. As a result, the two cointegrating vectors were reduced to two long-run relations — one including prices, wages and exchange rate, and the other containing money and wages. Money supply thereby was cointegrated with wage rate, but not with price level. Furthermore, upon testing ŽJohansen, 1988., wage rate turned out to be weakly exogenous in the latter cointegrating relation, thus supporting the hypothesis that the money supply accommodated wages.

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Prices and wages are set by the first cointegration vector and the corresponding ECMs. Namely, exogeneity tests related to the first cointegrating vector indicated that exchange rate was weakly exogenous, while prices and wages were endogenous. This gave price inflation and wage inflation setting equations, i.e. the corresponding ECMs, implying that both variables adjusted to the long-run relation between prices, wages, and exchange rate. In the case of prices, the long-run relation could be interpreted as a markup equation, and in the case of wages, as a trade-off between real wages and real exchange rate. Secondly, while exploring what has driven price and wage inflations, we found out that the system of four non-stationary variables was governed by the two independent stochastic trends, which exercised permanent effects on these variables. The first trend represents accumulated shocks to exchange rate, triggered by the balance-of-payments and foreign debt crises experienced by the former Yugoslavia in the 1980s. The second stochastic trend is a linear combination of accumulated shocks to prices and wages, i.e. accumulated aggregate supply shocks. These shocks can be assigned to a soft budget environment and the consequent quasi-fiscal deficit. Lastly, accumulated shocks to the money supply, i.e. aggregate demand shocks, had only a transitory impact on the variables. The estimated loading factors of stochastic trends and variance decomposition within VAR both indicated approximately the same relative importance of exchange rate and aggregate supply shocks in propelling the Yugoslav high inflation. Within aggregate supply shocks the dominant position is held by innovations in wages. Namely, depending on the structural VAR specifications or different orderings in the case of Choleski factorization, the impact of wages varied from a complete to a mild dominance over the impact of prices. These results point out that the Yugoslav high inflation in the 1980s, like some Latin American inflations Žcf. Montiel, 1989., can be partly explained by balanceof-payments view. This is not surprising since all these economies faced foreign debt and external sector crises. However, soft budget constraint obeyed by labor-managed firms and resulting quasi-fiscal deficit, had an equal share in propagating the Yugoslav high inflation. It turned out that the Yugoslav economy was particularly vulnerable to wage shocks, while money supply passively validated wage decisions. This result might bear a general relevance for transition economies. Finally, the fiscal view, that inflation is due to monetization of the narrowly defined fiscal deficit, obviously does not hold for the Yugoslav high inflation in the 1980s. It was the monetization of quasi-fiscal deficit, i.e. of excessive wage demands in the socially owned sector, that mattered.

Acknowledgements The authors are grateful to the anonymous referee for constructive comments. Responsibility for any remaining errors or omissions rests with the authors.

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