The role of the exchange rate policy in the Latvian economy

Abstract

The aim of the paper is to assess Latvia's exchange rate policy and its impact on two main goals of monetary policy: price stability and economic growth. The paper presents the role of exchange rate policy in small open economy such as Latvia and the effects of applying different exchange rate regimes in Latvia. At the beginning of transformation Latvia adopted a floating exchange rate system due to lack of sufficient foreign exchange reserves. Empirical analysis showed that during the period of functioning floating exchange rate system formally in Latvia, inflation rate has been reduced, but in the stabilization of the nominal exchange rate that is achieved by central bank intervention on the currency market. In order to accelerate the process of stabilizing the economy and achieve greater credibility of the financial markets, Latvia has adopted a fixed exchange rate system, which enabled the import of external validity. Economic performance, particularly price stability, reached in Latvia in the years following the change in the exchange rate, allows to conclude that the decision was right. The empirical analysis confirmed that in the initial period of the fixed exchange rate system in Latvia, the fight against inflation has been effective. However, in subsequent years, in terms of growing openness, Latvia has experienced the problem of increasing foreign capital inflows and the appreciation of the currency, which led to the decision of currency devaluation that caused inflation. From this it follows that the use of fixed exchange rate as an anti-inflationary anchor is effective only for a limited time.