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

160 Maria Minniti and Lidija PolutnikSlovenia, however, did not report those debts into its balance sheet nor recognizedthem as its liability toward commercial banks. To do so would have meant to beinsolvent from inception. Instead, commercial banks were obliged to continuekeeping these losses in their balance sheets as claims against the Yugoslaviancentral bank. Of course, under these conditions, most Slovenian banks becameinsolvent. Thus, to prevent the collapse of the banking system, the new Sloveniangovernment enacted a bank-specific rehabilitation program aiming at supportingbanks and preventing an epidemic of bank failures (Minniti and Polutnik 1999).The Slovenian experience with stopping inflationYeager (1981) identifies some general features of inflation whose analysis is fundamentalwhen investigating ways to reduce its incidence. Among these features, theimportance of the inflationary momentum, that is the ability exhibited by inflationto perpetuate and deepen itself, is especially emphasized. Specifically, the inflationarymomentum is described as having three distinct elements: (1) the credibilitycomponent; (2) the catch up component; (3) the expectations component. Clearly,all three elements are strictly related. The Slovenian case shows how the threeaspects culminated in a change of inflationary expectations. We argue such achange, together with a sound monetary policy, to be a necessary condition for thesuccessful interruption of the inflationary momentum.The formation of expectations may be discussed by considering the length of theadjustment process between change in prices and changes in real cash balances.Desired levels of real cash balances depend on actual changes in prices. In anenvironment characterized by rapidly changing inflation, actual levels of real cashbalances are not equal to desired levels. Once decided on the desired level,individuals can easily adjust their actual balances by spending them or by sellingother assets for cash. At the time of the Yugoslavian regime, Slovenes had done justthat by substituting dinars with foreign currency. Also, in order to choose anappropriate level for their cash balances, individuals look back in time in order toassess the current trend of prices (Cagan 1956). But there was no trend for theSlovenes. Thus, they could have easily continued holding foreign currency. Thisrisk was reinforced by the second element of the inflationary momentum, that is itscatch up component.The expectation component of the inflationary momentum makes the credibilityof an anti-inflation policy very important in determining the overall costs of thestabilization process. Although inflation is always a monetary phenomenon, thefact that it may be stopped with a drastic change in the political situation suggeststhat its creation and sanctioning have also political roots. Interestingly, muchhistorical evidence illustrates the importance of political and social pressure incausing inflationary policies. In the case of Slovenia, however, political and socialcomponents embraced disinflationary policies. With the exceptions of pricecontrols imposed by the Yugoslavian government, long-term contracts hadvirtually ceased to exist. Thus, there were no influential groups lobbying in favor ofmaintaining the status quo. In addition, “the paramount role of price stabilization