Inflation, exchange rates and the role of
monetary policy in Albania
by
Marta Muço (Anteon Corporation), Peter Sanfey (EBRD) and Anita Taci
(EBRD)
November 2003
Abstract
This paper examines the conduct of monetary policy in Albania during the transition
period. We identify various channels through which monetary policy can affect prices
and output and we assess their relative importance. Estimates from a vector
autoregression model (VAR) of key macroeconomic variables demonstrate the weak
link between money supply and inflation up to mid-2000. However, the move during
2000 from direct to indirect instruments of monetary control has helped to strengthen
the predictability of the transmission link from money supply to inflation. We
conclude by arguing that a move to formal inflation targeting could help promote the
transparency and credibility of monetary policy, but that such a move should be
introduced only when the country is ready for it.
1. Introduction
The performance of the Albanian economy throughout the transition period has been a
pleasant surprise to many people.1 Starting from a very low base in 1991/92, Albania
quickly entered on a path of high GDP growth and falling inflation, in conjunction
with the first moves towards serious market reforms. These achievements were
jeopardised but not permanently reversed by a period of turmoil and near-anarchy in
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early-1997, when several large pyramid schemes, into which much of the population
had put their savings, collapsed.2 Since then, the Albanian economy has again enjoyed
high annual growth rates and low inflation. This combination has been achieved in an
environment where financial sector development is still at an early stage and informal
markets are flourishing. Therefore, the role of monetary policy in influencing inflation
and growth is inherently limited. Nevertheless, increasing attention is being paid in
Albania to the role of monetary policy, and especially to the costs and benefits of
introducing new instruments and of moving to more explicit inflation targeting.
This paper has three main purposes. The first is to assess the conduct of monetary
policy in Albania during the transition and the extent to which the familiar
transmission mechanisms from nominal to real variables have worked in this period.
The second is to examine systematically, using time-series econometric techniques,
the interactions between several key variables, and the effect that the shift in recent
years towards indirect instruments of monetary control has had on these interactions.
Finally, the paper assesses whether a move to inflation targeting in Albania is either
feasible or desirable.
Section 2 of the paper examines the relevance of four different channels through
which changes in nominal variables can affect the real economy: interest rates;
exchange rates; credit rationing; and inflation expectations. The influence of some of
these channels on prices and output has been limited. The main reason is that financial
institutions in Albania are still at an early stage of development and have not been
able to play the role that they do in advanced western economies. Indeed throughout
most of the period, there is only a weak correlation, or none at all, between monetary
aggregates and either inflation or output. Interestingly however, the correlation
between money supply and inflation is much higher from 2000, when the central bank
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Table of Contents 1 Introduction: Australian Economy 2 1. 1 Real Gross Domestic Product 2 1. 2 Inflation 2 1. 3 Employment 3 1. 4 Current Account 3 1. 5 Exchange Rate 3 2 Monetary Policy 5 2. 1 Objectives of Monetary Policies 6 2. 2 Demand for Money 8 2. 3 Supply of Money 10 2. 4 Money Equilibrium 11 2. 5 Effects of Money Supply (Demand) 11 2. 6 Keynesians Vs Monetarists 12 3 Monetary Policy ...
switched from direct to indirect instruments of monetary control. Exchange rate
stability and price stability continue to be closely related, suggesting that the
exchange rate remains a key indicator for inflationary expectations.
Section 3 explores the correlations among several variables . money supply, inflation,
exchange rate, trade balance and migrants. remittances . by estimating a vector
autoregression model (VAR).
The results point to the stabilising role of remittances
on the exchange rate and hence on inflation in Albania.3 They also help to quantify
the extent to which shocks to the money supply can explain the variance in inflation
after mid-2000, when monetary policy shifted from direct to indirect instruments.
Section 4 explores the merits of having the monetary authorities adopt formal
inflation targeting. We argue that such a move could help promote the transparency
and credibility of monetary policy, in an environment where financial institutions are becoming more sophisticated. Nevertheless, there are considerable obstacles to thesmooth introduction of this policy, not least the lack of reliable statistics and information on current indicators. Section 5 concludes the paper.
2. Monetary policy in Albania
2.1 Background
The collapse of communism in Albania occurred in late-1990 and early-1991, and
was followed by a year of economic collapse, social disorder and widespread
emigration. The turnaround began in 1992; stabilisation measures were introduced
through a one-year reform programme that started in mid-1992. Under this
programme, the reduction of annual inflation, which at one point (in Autumn 1992)
was running at over 300 per cent, to below 20 per cent was a key objective. Money
growth was designed to be the principal nominal anchor of the programme, supported,
first, by a fiscal policy that had as a central objective the elimination of monetary
deficit financing by mid-1993, and second, by a tight credit policy. A two-tier banking
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... inflation in the early 1990 s required a harsh contractionary monetary policy, with extremely high short-term interest rates. For these observers, the Banks tight monetary policy ... there are several additional reasons to end zero inflation policies. Above all, this paper has demonstrated that ... two decades and allow greater room for growth. Exchange rates can, if necessary, be nudged downward without ...
system was also introduced around this time.
Under this programme, which was supported by the IMF and other international
institutions, monetary policy was based on direct instruments of monetary control.
This decision was dictated by the poor state of the banking system, the external debt
situation and the need to finance the large budget deficit. At the beginning of 1996
some licenses on private banking activity were issued to several foreign banks, paving
the way for a real market in that field. It is only recently that the consolidation of the
banking system has allowed indirect instruments of monetary control, including the
establishment of required reserves, a refinancing window and a liquidity requirement,
to replace direct instruments. New private banks have played a key role in
encouraging the use of indirect instruments of monetary control and inter-bank
competition.
The control of interest rates was an important part of Albanian stabilisation policy
during the transition. Real interest rates turned positive in the third quarter of 1994
(see chart 1) when inflation declined but they remained under central bank control
until the banking system began consolidating and monetary policy moved gradually
towards the use of indirect instruments. The Bank of Albania started to eliminate
direct control over interest rates at the beginning of 2000. Within a year the three
controlled interest rates on 3 months, 6 month and 12 months deposits were removed
and replaced with indirect instruments of monetary policy. The effects of these
changes are explored in detail below.
2.2 The transmission mechanism
There are a number of ways in which monetary policy can affect the real economy.
Four channels that operate in market economies are through: interest rates; credit
ceilings; exchange rate; and inflation expectations. The list is far from complete, but
in the Albanian case other channels such as equity prices or housing market are less
relevant, at least for now. It should also be noted that the effects can overlap to some
The Review on Inflation And Monetary Policy
... can policymakers control the inflation rate when they couldn't control the money growth rate? The historical record shows that central banks did not effectively control M 1, ... (1994), pp.77-97. Ball, Laurence, N. Gregory Mankiw, and Ricardo Reis. "Monetary Policy for Inattentive Economies," NBER Working Paper 9491, February 2003.Black, ...
extent, as explained more fully below.
As noted earlier, interest rates were under the direct control of the central bank until
August 2000. An important indirect effect of interest rates on inflation may have
occurred through the effect of high deposit rates on the demand for domestic currency
deposits, which in turn helped to maintain or even appreciate the value of the
domestic currency, thereby reducing import costs and prices. However, even though
banks typically had large excess reserves, the main bank in the country, the Savings
Bank, was prohibited from new lending throughout this period. Therefore, the amount
of new credit issued in the economy was small and the direct influence of interest
rates and credit allocation decisions on the real economy was correspondingly
negligible.
The exchange rate channel is perhaps the most promising route for explaining
inflationary developments in Albania. Exchange rate stability has in turn been aided
by the substantial inflows of remittances throughout the transition period.4 As chart 2
shows, there is a clear and strong link between exchange rate stability and inflation.
This link is seen most clearly during the anarchic period of early 1997, when both the
exchange rate and the inflation rate jumped sharply, only to fall rapidly once the
security situation was under control. The extent of the correlation is unsurprising in a
relatively open economy like Albania where foreign currency circulates widely, both
because of high inflow of remittances from Albanian working abroad and from
smuggling and contraband. In fact, empirical evidence in Haderi et al. (1999) and
Muço et al. (1999) showed that, for the early transition years (1993-96), the exchange
rate and remittances explained much more of the variation in inflation than changes in
the money supply do. We test below whether this result still holds true.
The stable exchange rate has undoubtedly played a key role in anchoring inflationary
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expectations, the fourth channel mentioned earlier. Since 1998, the central bank has
been announcing at the start of each year a clear quantitative target for annual
inflation, usually within a fairly narrow band (e.g. 2-4 per cent).
This increased
transparency has also helped monetary policy, especially in light of the relatively
successful performance to date by the central bank in achieving this target.
Turning to the relation between changes in money supply and inflation, Chart 3 shows
the co-movement between the two variables from 1994 to 2003. It is clear that there is
virtually no correlation up to 2000; during that time, changes in money supply were
driven by demand shifts. Sometimes they move in opposite direction, for example in
1994/95, when money growth was robust while annual inflation was falling rapidly to
single-digit levels, or in 1997 when money growth declined while inflation rose
sharply in the wake of the pyramid scheme crisis.
However, a positive correlation emerges after the introduction of indirect instruments
of monetary control in September 2000, as Chart 3 shows clearly. This change, which
is associated with the shift from direct to indirect instruments, is brought out by the
econometric results below. It is also consistent with Chart 4, which demonstrates that
there is a clear correlation between the annual growth of M1 and the Lek/USD
exchange rate after the introduction of the indirect instruments of monetary policy.
The relation between nominal and real variables in Albania is difficult to assess,
because the main measure of economic activity . gross domestic product (GDP) . is
estimated with a high degree of inaccuracy. The statistical coverage of the new,
emerging private sector is inadequate, and there exists a large informal sector that
probably accounts for at least one-third of GDP.5 In addition, GDP is estimated
annually only, whereas monetary aggregates such as inflation and exchange rates are
available at greater frequency. For these reasons, it would be useful for policy-makers
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... a correlation between GDP growth and inflation rate, i.e., both inflation and GDP growth is ... chart below, we see that average monthly salary growth rate exceeds both non-oil labor productivity growth rate and non-oil sector GDP growth ... when we start analyzing data from Azerbaijan. This idea ... real wages, which is very important while determining relationship between unemployment, inflation and growth. ...
to have available a good proxy for GDP, so that one could get a better sense of the
inter-relations among nominal and real variables.
Charts 5-7 show the correlations between real GDP growth and three variables:
import of machinery, energy consumption, and net exports. Because of data
limitations we correlate data series of different frequencies: annual data on real GDP
growth with monthly data on real growth of import of machinery and net exports, and
quarterly data on real growth of energy consumption. Charts 5-6 indicate that there is
a fairly close correlation between real growth in both import of machinery and energy
consumption, and real GDP growth.
Finally, we examine the correlation of GDP with net exports (see Chart 7).
Over the
whole period, there appears to be significant co-movement between to two variables.
Since, we have a longer data series for net exports compared to import of machinery
and energy consumption, and in the absence of a better alternative, we use net exports
as a proxy for GDP in our econometric analysis.
