Optimal Monetary Strategies for Central and East European EU Candidates

Miron J. Wolnicki

New York Economic Review, 2000, vol. 31, issue 1, 42-54

Abstract: The author argues that the high real interest rate policy persued in the Central and Eastern European Countries (CEEC) carries a risk of currency devaluation and recession when they join the European Monetary Union. Fear of demand-pull inflation has led the monetary authorities in the fast-growing CEEC to reduce the demand for credit by raising real interest rates, exceeding the interest parity relation with major EU markets. This policy has caused speculative capital inflows, distortion of capital allocation, real currency appreciation and trade deficits. Currency overvaluation will require a corrective devaluation via-a-vis the Euro during the final stages of accession to the EMU. Such a "last minute" correction is likely to destabilize CEEC banks and businesses by upsetting the balance between short-term foreign currency liabilities and long-term domestic assets. The author proposes that the CEEC EMU candidates adopt flexible inflation targeting instead of focusing on interest rates as a main disinflationary tool. This would assure accumulation of the proper amount of foreign currency reserves, reduce the current account deficit and ensure a smooth transition to the EMU. The new policy should be focused on defining and adopting a band of acceptable inflation rate targets and a "step down" path to alignment with the Euro.

Date: 2000
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