Advantage of Fixed Exchange Rate Regime in Latvia Konstantins Benkovskis Head of Monetary Research and Forecasting Division

Bank of Latvia monetary policy Final goal is to maintain the stability of prices Intermediate goal is fixed exchange rate of lat: –From 1994 to 2004 lat was fixed to SDR currency basket: LVL = 1 SDR –Allowed fluctuations of lat were +/-1% In January 2005 Latvia entered Exchange Rate Mechanism II (ERM II) –Lat is fixed to euro: LVL = 1 EUR –Although required band was +/-15%, Latvia keeps a narrower corridor of +/-1%

Reasoning for the fixed exchange rate regime in Latvia Latvia is an extremely small and open economy Fixed exchange rate regime provides a clear nominal anchor Changes in regime will lead to a loss in Central Bank credibility Latvian business cycles are converging towards euro area business cycles Exchange rate stability stimulates exports Foreign debt is mostly denominated in euros Inflation expectations in Latvia are adaptive

Latvia is an extremely small and open economy Latvia’s economy is: –Small (2.3 millions of inhabitants, nominal GDP in 2008 was 23.1 billion EUR) –Open (ratio of exports and imports of goods and services to GDP in 2008 was 97%) As a result, there is a high pass-through of exchange rate fluctuations to domestic prices The best way to stabilize prices is to fix exchange rate!

High exchange rate pass-through to prices Response to exchange rate shock (1% depreciation of national currency) Source: K.Benkovskis, D.Stikuts “Latvia’s Macroeconomic Model”, Bank of Latvia,

Fixed exchange rate regime and credibility issue Fixed exchange rate regime provides a clear nominal anchor: LVL = 1 EUR The stability of the exchange rate for almost 15 years increase the credibility of the Bank of Latvia Changes in monetary policy regime will immediately lead to a loss in the credibility of the Bank of Latvia

Latvian business cycles are converging towards euro area business cycles According to the Optimal Currency Area (OCA) theory, country can join currency zone (or imply fixed exchange rate), if business cycles are sufficiently correlated The correlation between Latvia’s and euro area’s business cycle is increasing Correlation between Latvia’s GDP growth and the common factor for real GDP growth in the euro area Source: A.Melihovs, A.Zasova “The Baltic States and Europe: Common Factors of Economic Activity”, Bank of Latvia,

Exchange rate stability stimulates exports More than a half of Latvia’s exports is going to euro area or countries, which fixed their exchange rate to euro (57.2% in 2008). Exports is negatively influenced by the volatility of bilateral exchange rate –Exchange rate volatility increase by 1% decreases exports by 0.08%. Fixed exchange rate of lats to euro stimulates Latvia’s exports Source: M.Bitans, E.Kauzens “Impact of the Euro Adoption on the Economy of Latvia”, Bank of Latvia,

External debt is mostly denominated in euros External debt of LatviaLong-term external debt of Latvia

Effectiveness of monetary policy is constrained by the high degree of loans in euro Currency composition of domestic credit to private sector (millions of lats)

Inflation expectations in Latvia are adaptive According to research of the Bank of Latvia, inflation expectations are adaptive –Expectations for the next 12 months are to a large extent driven by perceived inflation in the current period Adaptive expectations make it harder to target inflation, as larger changes in interest rate are needed Households’ perceptions and expectations of inflation Source: K.Benkovskis, D.Paula “Inflation Expectations in Latvia: Consumer Survey Based Results”, Bank of Latvia,

Evidence from the small open economy DSGE model for Latvia One way to compare two different exchange rate regimes is to estimate a Dynamic Stochastic General Equilibrium (DSGE) model Short model description: –Small economy and world economy, modelled as a continuum of small economies –Representative household, maximizing consumption and leisure –Firms maximize their profits, reoptimising their price (Calvo price setting mechanism) –Monetary policy is defined by an interest rate rule Source: V.Ajevskis, K.Vitola “Advantages of fixed exchange rate regime from general equilibrium scope”, Bank of Latvia, mimeo

Interest rate rule describes monetary policy in the model Interest rate rule: –Central Bank’s monetary policy adjusts for movements in inflation, output and nominal exchange rate –For the case of fixed exchange rate Ψ 3 will be high, while Ψ 1 and Ψ 2 will be low –For the case of inflation targeting Ψ 1 will be higher, while Ψ 2 and Ψ 3 will be lower Policy rate Inflation Output Exchange rate

Estimated coefficients of the small open economy DSGE model for Latvia Model coefficients are estimated for Latvia using Bayesian technique Most important parameters: –Openness ratio (α): –Phillips-curve parameter (λ): 1.6 –Interest rate rule for fixed exchange rate regime: Sensitivity to inflation (Ψ 1 ): 1.26 Sensitivity to output (Ψ 2 ): 0.03 Sensitivity to exchange rate (Ψ 3 ): 44.8

Fixed exchange rate Vs flexible exchange rate Fixed exchange rateFlexible exchange rate Ψ 1 =1.26, Ψ 2 =0.03, Ψ 3 =44.8Ψ 1 =2.5, Ψ 2 =0.6, Ψ 3 =0.6 Volatility of exchange rate Volatility of output Volatility of inflation What if we change fixed exchange rate regime for a flexible exchange rate with additional concern about inflation and output?

Fixed exchange rate Vs flexible exchange rate Small open economy DSGE model results: –According to estimations, fixed exchange rate regime provides the smallest inflation volatility in Latvia –Switch to a flexible exchange rate with more concern about inflation (inflation targeting) would increase exchange rate volatility and also inflation volatility

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