Money and Markets: Essays in Honor of Leland B. Yeager

No-name money 157bank chose the one to one conversion ratio, in part to preserve the goodwill of thepopulation and prevent the re-emergence of old fears caused by negativeexperiences with past currency conversions. The argument that a more favorableexchange ratio would raise confidence in a new currency unit and lower inflationaryexpectations was rejected. So were other, more drastic, arguments involvingdifferent conversion rates depending on the owner, form, and value of the assetconverted. 16In a sense, the process by which the value of the tolar was eventually determinedin the market can be thought of as being analogous to the float of a new companywith very little track record on the stock market. People may be persuaded to buy itsshares initially, just as people were initially persuaded to hold tolars. But how thevalue of the shares will change in the future is anybody’s guess and it depends, to alarge extent, on how the company is managed. Likewise, the value of the tolarstabilized in terms of goods and other currencies as soon as it became clear that itwas managed well by the central bank. This meant that more and more peoplewere willing to hold it, and to hold increasing amounts. As expected, inflationdeclined, the demand for real cash balances in tolars increased, and the inflationarymomentum was interrupted. 17Indeed, in a situation like that of Slovenia in 1991, one cannot emphasize enoughhow important it was for the government strategy to be in tune with a winningcoalition of voters. Since a real possibility existed that inflationary expectationsassociated with the dinar would extend to the tolar, a crucial aspect of the successof the reform was the Slovenian central bank’s ability to successfully leveragethe unstable economic environment and to influence popular expectations,thereby breaking the inflationary momentum. On October 8, 1991, in addition tointroducing the tolar as sole legal tender in Slovenia, the Monetary Unit CurrencyAct also established that the new national currency was to be convertible from thebeginning, and was to trade freely against the dinar and other internationalcurrencies.The importance of the coalition between the Slovenes and their monetaryauthorities is further illustrated by comparing the Slovenian experience in stoppinginflation with the inflationary dynamics within the Croatian economy over theperiod January 1992–December 1999. In Croatia, the reform has not been able tocreate the alignment of incentives between monetary authority and populationwitnessed in Slovenia. In fact, the structural break in the inflationary processcorresponding to the Croatian anti-inflationary stabilization program of October1993 has shown the Croatian inflation to be positively related to wage growth andcurrency depreciation (Payne 2002). Despite almost 10 years of low inflation,Croatia continues to experience high levels of currency substitution. Roughly,three-quarters of bank deposits and currency in circulation are held in foreigncurrency, especially US dollars and euros (Kraft 2003). This significantly limits theability of the Croatian central bank to conduct its own independent monetarypolicy. The country payment system is also affected since banks, in trying to avoidbalance sheet mismatches, are forced to link via indexes all credit transactions tothe exchange rate. Such an environment increases credit risk, reduces the amount