Macroeconomic Model of Transition Economy: A Stochastic Calculus Approach

An integrated stochastic macroeconomic model of transition economy at the early stage of reforms with optimising representative risk averse agents is constructed. The equilibrium growth rate of the economy, real asset returns, domestic money demand, and expected inflation rate are determined as functions of the exogenous risks in the economy. The main issue addressed are: domestic money demand, currency substitution ratio, expected rate of inflation, real asset returns, the equilibrium growth rate of the economy as well as government ability to control these variables. Analysis of the model finds that the equilibrium growth rate of the economy is not independent on the monetary and fiscal policies but can be affected by the government through its ability to fix the real cost of capital for the firm, expenditure and monetary policy parameters.

Introduction: The process of transition from the centrally planned to an open free market economy has been on its way for about nine years already for the countries in Eastern Europe and slightly less for the countries of the former Soviet Union, but still the level of theoretical understanding and the number of theoretical models of transition, addressing the questions of how do specific features of transition economies (menu of assets available to economic agents, absence of well developed financial markets such as – stock and bond markets, and the system of financial intermediaries) affect the level of macroeconomic performance and alter conventional results,remain fragmented, limited in scope and quantity.

Apart from setting up a specific model and solving it, the paper rises and addresses the following three issues: the issue of macroeconomic modelling, the issue of uncertainty, and the issue of integrating financial markets into macroeconomic framework. All of them are considered in relation to the problems of transition and development economies.

Author: Vadims Sarajevs

Source: Institute for Economies in Transition, Bank of Finland

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