External and internal macroeconomic shocks in case of small economy with the currency board

Abstract

External and internal economic shocks can threaten the macroeconomic stability of a small economy. In the currency board regime, there is no role for the Central Bank as a macroeconomic stabilizer in the event of an external or internal shock. In this paper, the research is based on the analysis of eight countries with small economies with currency boards or discretionary monetary policy. The impact and connections between changes in EURIBOR, interest rates, inflation measured by the GDP deflator, money supply and GDP in the period 1997-2015 are analyzed. The paper proves that in countries with a currency board, whose regimes have a harmonized relationship with the European Central Bank and EURIBOR, interest rate shocks are less pronounced. The analysis of the links between EURIBOR, interest rates, money supply, inflation and GDP is not statistically significant in the "experiment" countries. In the control sample of countries with a variable exchange rate, the situation is heterogeneous for individual countries, but statistical significance has been determined in relation to EURIBOR and inflation. We conclude that EURIBOR may be one of the generators of exogenous shocks. In the case of Bosnia and Herzegovina (B&H), there are much more significant internal transmission mechanisms that lead to macroeconomic imbalances. The growth of deposits was preceded by the growth of loans and money supply. This led to a fall in interest rates which the Central Bank of BiH (CBB&H) could not influence due to the currency board. However, the fall in interest rates did not yield the expected results. GDP has shrunk, inflation is falling, while at the same time the high unemployment rate has remained unchanged. The nominal exchange rate of the domestic currency was determined by law, but there was an appreciation of the real exchange rate, which affected the increase in the foreign trade imbalance. The result of the currency board is price stability, nominal exchange rate stability and money supply growth. Negative results are: appreciation of the real exchange rate, faster growth of imports and maintaining a very high unemployment rate. Macroeconomic developments in the BiH economy do not always have the right course that can be expected in mature economies. The achievements and applicability of standard macroeconomic policies are very limited.

Keywords

• external shocks
• internal shocks
• currency board
• interest rates
• euribor
• monetary policy