Transition Economics and Hyperinflation A learning-based approach in the case of Poland
Jacek Barszczewski
Universitat Autònoma de Barcelona
January 27, 2019
Abstract
This paper examines the persistence of inflation in Poland during
the transition period from socialist to market economy. It will be argued, that roots of this persistence could be found in a long process
of agents adjustment to new market conditions. To explain the character of this process, a model with restricted rational learning will be
implemented. However accounting for results, it is concluded that the
basic learning model poorly reproduces the volatility of the price level.
Thus, probably further extension of the model are needed.
Keywords: Poland, transition, hyperinflation, learning
1
Introduction
In the second half of the 80’s Poland was in a deep crisis. The socialist
economy turned out to be extremely inefficient. Shortages, long queues,
strikes were a common sight. The collapse of the Iron Curtain and a set
of reforms introduced at the beginning of 90’s brought Poland back to the
developing path. The economy was stabilised within a relatively short period
of time. Thanks to launched reforms, on the cups of the new century Poland
was ready to become a member of the European Union. However, not all its
problems were solved. Despite of radical reforms in 1990, inflation in Poland
seemed to be persistent[7]. The price level was still significantly higher than
the EU average, which was around 3%. Moreover, the inflation in Poland
was between 7% and 15% in the last years of 90’s.
Using monthly data from 1990(1) to 1999(12), this paper sets out to
investigate the persistence of inflation in Poland. Results of estimation are
thought to provide answer for the following question: can we explain the long
period of high inflation by high levels of seniorage? Does learning processes
explain the persistence of inflation in Poland? Can we assume that agents
had a restricted rational learning model? Learning was introduced to verify
above-mentioned hypothesis by using modification of the model proposed
by Marcet and Nicolini[10] for South America countries. The outcomes of
the model is discussed to answer to formulated hypothesis.
This paper is organised as follows. Section II discusses the roots of
hyperinflation in Poland and reviews literature on the transition process
from socialist to market economy with a focus on the explanation of inflation
persistence. Section III presents the theoretical framework of the model that
is used to determine Polish inflation empirically. Section IV discusses sources
of the data used for the model and presents results of the simulation. Section
V concludes with a discussion.
1
2
Roots of hyperinflation in Poland and reforms
of transition process
One of the symptoms of late 80s crisis in Poland was constantly fast increasing prices. As Kolodko et al.[8] noticed, an inflation in a socialist economy is
characterised by a duality - it consists of a general rise of price level typical
for market economies and shortages typical for socialist economies. This
phenomenon is called shortageflation in the literature [9].
In the Polish case there were several factors which led to hyperinflation1 .
Firstly, the rise of prices was accelerated by an execution of a ”price-andincome” operation in February 1988. Instead of reduction in average real
wages, the latter were increased. In the light of common shortages, those
operation has only ”statistical” nature. As a result, strong pressure on prices
appeared because of an excessive labour cost. Another factor are the result
of the Round Table negotiations - ”makretization” of agriculture and ”the
general wage and income indexation system”. The ”marketization” of the
agriculture mainly consisted of a liberalisation of retail prices of food, which
were artificially depressed by government in socialist economy. The price
level acceleration was additionally fuelled by the effect of full indexation.
There was also another additional accelerator of inflation. A retroactive
rise of state purchases prices for agriculture products caused a breakdown
in public finance. It rapidly worsened the situation of the state budget. As
Kolodko at al.[8] pointed out inflationary budget expenditures were excessively growing, especially for subsidies to the state sector production. On
the other hand, budget revenues were lowered by a weak fiscal discipline.
The government deficit was nearly 8% and both loss-making Polish companies and the government deficit were financed by the rapid expansion of
money and credit.
Above-mentioned factors led to a sharp increase of inflation during the
summer 1989, when the consumer price index soared to 55% - figure 1. The
situation got even worse at the beginning of 1990, when in January the
inflation hit a peak amounting nearly 80%. Deep financial and social crisis
together with the soaring inflation forced the new-formed government in
autumn ’89 to take radical steps. A major stabilization began on January
1, 1990 with the introduction so-called Balcerowicz Plan. The plan consisted
of several components[16]: changes in a monetary and fiscal policy, further
liberalization of prices, an introduction of a convertibility of zloty and a
restrict revenue policy.
The main goal of reforms in monetary policy was to slow down the increase of nominal money supply and increasing nominal interest rates. Addi1
The use of term ”hyperinflation” in the context of inflation in Poland in ’90s during
the transition period still seems to be controversial. Accuracy of a usage of this expression
depends on the assumed definition. However, in the light of the outgoing debate I propose
to use ”hyperinflation” term here
2
Figure 1: Inflation from Apr-89 to Sep-90 (previous month = 100)
tionally, financing of the deficit by National Bank of Poland (Polish Central
Bank - NBP) was strictly limited. The NBP also gained wider independence of the government. In fiscal policy the main change was a reduction
of the deficit from 8% of GDP in 1989 to 0,8% in 1990[8]. The significant
decrease was mainly obtained by cuts in subsidies and state investments.
”The general wage and income indexation system”, introduced as a result
of the Round Table, was lifted. Instead, the new tax (so-called popiwek ) on
increase of wage fund was introduce.
The key role in the process of fighting with hyperinflation was devoted
to the National Bank of Poland. One of the most powerful tools, which were
used, was introducing a fixed exchange rate policy. During the communism
period there were two foreign exchange market in Poland. An official one
controlled by the government and an unofficial one controlled by a network
of touts. The official exchange rate of PLN/USD was permanently strongly
understated. This led to the situation in which the size of the black market
was bigger than the official one (up to 7 times)[6]. In January 1990 the
exchange rate PLN against the dollar was made real and a fixed exchange
rate was implemented[1]. In the next step in May 1991 a fixed rate against
a basket of five currencies was introduced. Crawling peg with monthly rate
of devaluation declining steadily from 1.8% to 1.2% was conducted in the
3
period between October 1991 and May 1995. As a next step of liberating
the exchange rate, the NBP introduced a crawling band system, with a
fluctuation band increasing from ±7% to ±15%. The last point of the reform
was the introduction of a free-floating exchange rate system in May 2000.
The implementation of the Balcerowicz Plan brought fast effects, especially in monetary policy. After a few months the price index stabilized
on a moderate level. What is more, it was done together with keeping the
austerity in fiscal policy. In 1990 the budget was closed with a surplus
amounting 0.7% of GDP[8]. However, when times went by new economic
problems loomed. The recession turned out to be deeper than reforms authors assumed. Polish society after the communism period was not ready to
face unemployment problems characteristic for markets economies. What is
more, inflation turned out to be more persistent then it had been thought
before - see figure 2.
Figure 2: Inflation in 1989-1999
There are several researches which tried to explain the persistence of
inflation in Poland[7]. Welfe[19] was investigating the cointegration relationship between prices and wages. He claimed that the dominant factor
generating inflation in Poland between 1991 and 1996 was a raise in wages.
An opposite explanation was provided by Brada and Kutan[3]. In their
paper they used causality tests and a variance decomposition method to
4
analyse the roots of inflation in three transition countries: Poland, Czech
Republic and Hungary. Nominal wage growth and money supply turned out
be unimportant contributors to the inflation process in the short run. Brada
and Kutan argued that there are three main factors influencing the inflation
process: foreign prices, exchange rate and past path of the process, which
can be interpreted as an inflationary expectation of the population.
Mass et al.[11] among causes of inflationary expectations persistence
named: government’s use of the central bank or of commercial banks to
finance deficit, high initial value of inflation (excess of 10%) and a failure to
combat the fiscal roots of inflation. As Brada and Kutan[3] suggested, all
of these factors one can find to a greater or lesser extent in each of three
analysing by them transitions countries.
3
3.1
A Theoretical Framework of the Models
Baseline model
The basic assumptions of the model are similar to those made by Marcet
and Nicolini[10]. The model consists of a set of equations, which determines
the demand for real balance and the government budget constrain relating
money creation and changes in international reserves of the central bank.
In the paper, it is assumed that the demand for real balance is given by
the following equation:
Pe
MtD
= φ − γφ t+1
Pt
Pt
(1)
e
where MD
t is a nominal demand for money, Pt is price level in period t, Pt+1
is agents expectation in period t for the price level in period t+1. δ and λ
are given parameters.
Similarly, under the assumption of a floating exchange rate, the government budget constrain is given by the following equation:
Mt = Mt−1 + dt Pt
(2)
where dt is a real value of a seigniorage. The seigniorage is defined in this
model as difference between nominal money supply in period t and period
t-1. In this model seigniorage is the only source of financing deficit by
government. Equations (1) and (2) together with the hypothesis of agents
expectations determines the sequence of values for {Mt , Pt }∞
t=1 in periods
with the fixed exchange rate.
However, as it was mentioned before, in analysing the period in Poland
fixed exchange rate was introduced. It means, that the central bank was
trying to keep the inflation in Poland equal to the foreign inflation. In
this case it is needed to change the equation for the government budget
5
constrain. The money demand given by equation (1) will not match money
supply given by (2). Following Marcet and Nicolini[10], in this paper it is
assumed that as it is in a standard fixed exchange model, the central bank is
adjusting international reserves to achieve the right level of money balances.
In this case, instead of money supply given by (2), it is given by the following
equation:
Mt = Mt−1 + dt Pt + et (Rt − Rt−1 )
(3)
where et is an exchange rate in a period t and Rt is a nominal value of
international reserves in a period t. Equations (1) and (3) together with
hypothesis of agents expectations determine the equilibrium values for {Mt ,
Pt }∞
t=1 in periods of floating exchange rate.
3.2
Model with Restricted Rational Learning
The model of restricted rational learning used to explain persistence of inflation in Poland in 1990’s is based on the model proposed by Marcet and
Nicolini[10] to explain the phenomenon of recurrent hyperinflation in South
American countries in 1980’s. In the model it is assumed that using information from the past agents learn about the inflation process:
e
Pt+1
= βt
Pt
(4)
Following Marcet and Nicolini[10], the paper assumes that the learning
mechanism is given by the stochastic approximation algorithm:
βt = βt−1 +
1
(πt−1 − βt−1 )
αt
(5)
for given β0 . This stochastic approximation can be interpreted as perceived
inflation βt is updated by the term that depends on the last prediction error.
The last prediction error is weighted by the gain sequence α1t . Equation
4 together with the assumption about the evolution of α1t determines the
learning mechanism introduced into the model.
There are two standard assumption for the gain sequence. The first
one is αt = αt−1 + 1. This assumption cause that learning process is an
equivalent of the OLS estimator of the inflation mean. In this case αt = t,
so the learning algorithm can be rewrite as:
t
βt+1
1 X Pi
=
t
Pi−1
(6)
i=1
From the equation (6) it can be concluded that OLS gives equal weights to
all past observation. It makes this algorithm predict inflation ”well” during
6
the stability period, because it ignores small shocks. On the other hand,
forecasts generated by least squares are ”wrong” during the hyperinflation
period, because it is extremely slow in adapting to the rapidly changing
price level.
The second standard assumption for the gain sequence is called ”constant
gain”. In this case αt is constant over time and equal ᾱ. In this case, an
equation for a perceived inflation can be rewritten as:
t
βt+1
1X
1 Pt−i
=
(1 − )i
ᾱ
ᾱ Pt−i−1
(7)
i=0
Following Marcet and Nicolini[10] a learning mechanism used in this
paper mixes both alternatives: OLS and ”constant gain”. OlS will be used
in periods with stable inflation while constant gain will be introduced when
instability appears. It means that as long as agents are not making large
mistakes they use OLS algorithm. If the large mistake is detected then they
introduced ”constant gain”. Formally, described condition can be expressed
as follows:
αt = αt−1 + 1 if |
πt−1 − βt−1
|<v
βt−1
(8)
= ᾱ otherwise
Using equations (1), (3) and (4) it can be shown that the gross inflation
rate at time t is equal:
πt =
φ − γφβ̂t−1 + et (Rt − Rt−1 )/Pt−1
φ − γφβ̂t − dt
(9)
Equation (9) implies that inflation in the model is well defined only if at
each t nominator and denominator are positive (otherwise the real balances
demand could become negative). However, there is no restriction within
the model preventing these constraints from being violated. What is more,
equation (9) implies that the price level is not bounded[2]. Given the numerical problems that this can generate when estimating the parameters, it
is assumed that there exists constants δ U , δ L > 0 such that δ L < πt < δ U
for every t. Those two constrain can be rewritten as follows:
(φ − γφβ̌t − dt ) > 0 and
δL <
φ − γφβ̂t−1 + et (Rt − Rt−1 )/Pt−1
φ − γφβ̂t − dt
< δU
(10)
If any of those constraints is violated than equation (9) does not longer determine the level of inflation. In this case, it is assumed that the central bank
7
tries to keep the inflation from the previous period. So, πt is determined
randomly by the following normal process:
πt ∼ N (πt−1 , σ)
(11)
The proposed process for the inflation in period, when constrains for learning
process are violated, is based on proposal made by Pincheira and Medel[15].
In their paper they showed via simulations that persistent stationary inflation processes may be well predicted by unitroot-based forecasts.
The above system of equations fully described the performance of the
model with restricted rational learning.
4
4.1
A Estimation of the Models
Data
A data set consisting of monthly observation of the consumer price index
(CPI)[17], the narrow nominal money supply (M1)[14], the international reserves of NBP[13] and the nominal gross domestic product[18]. Specifically,
the letter one was expressed in Special drawing right. The exchange rate
XDR/USD[5] and USD/PLN[12] was used to express the international reserves of NBP and gross domestic product (GDP) in Polish zloty (PLN). The
sample period runs from 1990 to 1999. All data is taken from the OECD
data set, except CPI which was taken from Statistics Poland, GDP which
was taken from The World Bank and XDR/USD exchange rates which was
taken from the Federal Reserve Bank of St. Louis. All estimations were
carried out using the Matlab R2018b software package.
4.2
Estimation results
To generate estimation, values should be assigned to parameters of money
supply (φ, γ) and lower and upper bounds of the inflation process (δ U , δ L ).
The value of the parameters (φ = 0.92, γ = 0.09) were chosen based on the
sequence of Monte Carlo simulation in order to replicate some patterns of
the Polish inflation. The value of lower and upper bounds was arbitrary
chosen as δ L = 0.95 (the central bank doesn’t want to allow for deflation
higher than 5% per month) and δ U = 1.8 (the central bank is trying to avoid
the hyperinflation from January ’90 onwards).
If any of constrains is violated, then inflation is normally distributed
with mean equal πt−1 and variance equal variance of the inflation in data
(σ = 0.0057). The parameter v, following Marcet and Nicolini[10], was set
equal to 10 percent.
To replicate the original process of inflation in Poland, initial believes of
agents were chosen to equal inflation in the previous period. Similarly as it
8
was in Marcet and Nicolini[10] the process for αt under the assumption of
”constant gain” is set to α̂ = 5.
Figure 3 presents results of the estimation of CPI in Poland by a model
with restricted rational learning. An average of CPI simulation is significantly higher than in data - table 1. The CPI in model simulation does not
follow a slow, but decreasing process as it is in the data. There are a lot
of variabilities in the simulation outcome. The price level has a constant
tendency to grow. The variance of the CPI process is also much higher than
in data. To sum up, the outcome of the simulation does not illustrate the
volatility of CPI in Poland. The model with restricted rational learning does
not explain the persistence of inflation in Poland.
Figure 3: Real data and model estimation of CPI
Real data
Model simulation
mean
1.0302
1.1637
variance
0.0057
0.0311
max
1.7960
1.7960
min
0.9910
0.9519
Table 1: The results of Monte Carlo simulation for the model with restricted
rational learning
9
5
Conclusions
The model with restricted rational learning poorly performs in the case of
Poland. The path of inflation generated by the model is characterised by
a significantly higher mean. When it comes to the variance, the outcome
of the model is even worse - the inflation process generated by the model
volatilities 6 times more than the real inflation process.
There are several possibilities, which probably contributed to the failure of this model. Cukrowski et al.[4] concluded that there was a weak
relationship between inflation and seniorage. It means that the theoretical
basis of the model could be not sufficiently strong in case of Poland. What
is more, Brada and Kutan[3] showed using a VAR model, that monetary
policy conducted by the NBP was rather quantitatively unimportant as a
factor influencing the price level.
However, there are several possibilities to extend the model to obtain
more satisfying results. First of all, as Brada and Kutan[3] noticed, the
import prices and changes in nominal interest rates had a important role
in creating transitory shocks. Their founding was based on analyses of a
VAR model system. Probably extending the model by import prices and
changes in nominal interest rates can significantly improve the outcome of
the model. Another proposition of an extension of the model was made by
Sámano et al. [2], who analysed inflation in Mexico. In their paper, they
added to the model changes in exchange rates. This extension significantly
improved outcome of the model. It is recommended to analyse if aforementioned extensions could significantly influence the outcome of the model with
restricted rational learning.
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