IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
Latvia's boom, bust, and recovery provide a rare case study for macroeconomists: an economy that responded to a balance-of-payments crisis by maintaining its currency peg and adjusting through internal devaluation and front-loaded consolidation. This paper lays down the facts about Latvia's boom and bust and analyzes the policy response and the mechanics of the adjustment through internal devaluation. While Latvia's adjustment was very costly, with a large drop in output, a big increase in unemployment, and substantial emigration, it was eventually successful. The internal devaluation worked faster, though quite differently, than what had been expected. Productivity increases, rather than nominal wage cuts, drove much of the unit labor cost reduction. These then led to an increase in profit margins, rather than a decrease in prices, and to a surprisingly fast supply response. The strong front-loaded adjustment did not prevent the recovery. The lessons of the Latvian experience for other countries may however be limited, since many of the elements of the eventual success appear to have been due to factors largely specific to Latvia, factors that are not present in southern euro countries, in particular.
A long-standing conjecture in macroeconomics is that recent declines in exchange rate pass-through are in part due to improved monetary policy performance. In a large sample of emerging and advanced economies, we find evidence of a strong link between exchange rate pass-through to consumer prices and the monetary policy regime's performance in delivering price stability. Using input-output tables, we decompose exchange rate pass-through to consumer prices into a component that reflects the adjustment of imported goods at the border, and another that captures the response of all other prices. We find that price stability and central bank credibility have reduced the second component.
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