GROWTH, NONTRADABLES, AND PRICE CONVERGENCE IN THE BALTICS

This paper reviews the strong real exchange rate appreciation observed in the three Baltic countries following macroeconomic stabilization. This is primarily a consequence of the undervalued real exchange rates of the new currencies, which is reflected in price levels that are lo wer than in countries with similar income levels. A tendency for conti nued real appreciation is to be expected as part of the transition tow ard higher income levels, due in part to differential productivity gro wth rates in the tradable and nontradable sectors, as illustrated in a two-sector general equilibrium model. In the absence of an appreciati on of the nominal exchange rate, this real appreciation will occur thr ough inflation rates that are higher than in industrial countries. Pro vided that the current prudent economic policies are continued, such h igher inflation will not threaten macroeconomic objectives and may ind eed be viewed as an indication that the transition process is progress ing as expected. (C) 1996 Academic Press, Inc.