This paper offers an insight on short-term effects of inflation on unemployment level in Bosnia and Herzegovina (BiH). The relationship is tested on country level as well as individually on the level of its entities: Federation of Bosnia and Herzegovina, Republika Srpska, and Brˇcko District. BiH has been chosen for this study because of its unique monetary arrangement, that is, the currency board system adopted in BiH, fixing its exchange rate to the Euro and also due to the high unemployment rate that persists since the independence of the country. This type of monetary system results, of course, in a strong relationship with the European monetary system as well as the European Central Bank (ECB). The main goals of the ECB are to maintain price stability in the EU, to achieve a low-level of unemployment and to facilitate economic growth with low inflation. However, due to recent financial and economic events, mostly the financial crisis in Greece, and possible financial breakdowns in Spain and Italy, the commitment of the ECB to maintain low inflation is challenged by required bailouts of the EU member countries that face financial difficulties. Since Bosnia and Herzegovina operates within a currency board regime with its exchange rate fixed to the Euro, the inflation rate of BiH is expected to be a reflection of inflation in the EU (the correlation between the monthly CPI of Bosnia and Herzegovina and the EU amounts to 0.94, based on a data sample of monthly CPI from April 2008 to June 2012). As a result, any change in monetary policy of the European Union (EU) might be a blessing or a curse for BiH, depending on the country’s inflation-unemployment relation. If the relation is negative, as proclaimed by supporters of the Phillips curve, a possible increase in inflation might decrease the high level of unemployment in the country which, at the end of 2012, amounted to 45% and was one of the highest unemployment levels in the world. However, if the inflation-unemployment relationship is positive, a higher inflation rate in the EU might indeed burden the economy of BiH further and as a result even increase pressure on employment. This possible negative long-term effect of inflation on unemployment has been highlighted by Ahrens and Snower. Moreover, estimating the extent of wage rigidity in BiH is important for understanding monetary policy transmission mechanism between the Euro area and BiH and to analyze whether wage curve mechanisms are also in force in post-war BiH.
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