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Real exchange rate targeting and inflation in Turkey: An empirical analysis with policy credibility
WorldDevelopment. Vol. 25, No. 10, pp. 1717-173(1, 1997 © 1997 Elsevier Science Ltd All rights reserved. Printed in Great Britain 0305-750X/97 $17.00 + 0.00
Pergamon PII: SO305-750X(97)O0061-2
Real Exchange Rate Targeting and Inflation in Turkey" An Empirical Analysis with Policy Credibility TURAN
EROL
Erasmus University and Tinbergen Institute, Rotterdam, The Netherlands and SWEDER
VAN
WIJNBERGEN*
University o f Amsterdam, The Netherlands Summary. - - In this paper we make an empirical investigation into the conflict among objectives under a real exchange rate policy, i.e. between the trade balance and domestic inflation. This occurs when the nominal exchange rate is managed to achieve a certain level of the real exchange rate in order to main external competitiveness. Our empirical analysis draws on the Turkish case, whereby the exchange rate has been the key policy instrument since the 1980s. The results from the simulation experiments with a well-defined macromodel, where the devaluation expectations are explicitly considered, indicate moderate inflationary consequences of a real exchange rate policy based on the relative purchasing power parity (PPP) rule in Turkey. Moreover, a real exchange rate appreciation is found to be contractionary. These are common characteristics of the demand-determined output case. Another major conclusion is that the exchange rate policy can provide an anchor for price stability only if it is credible. © 1997 Elsevier Science Ltd
Key words -- real exchange rates, inflation, policy credibility, Turkey
1. INTRODUCTION In inflation-prone countries authorities engage in real exchange rate targeting by managing the nominal exchange rate. The aim is to maintain international competitiveness through realistic real exchange rates. Better trade and capital account balances are in turn essential to finance the often high existing official foreign debt. Under these conditions, the real exchange rate, a key relative price in any open economy, usually proves to be the most popular real target. l The underlying exchange rate system is usually a passive or active crawling peg regime. The policy rule governing the passive crawl is stochastic because it is linked to the behavior of other economic variables within the system. Relative purchasing power parity (PPP) is the most commonly adopted passive crawl rule, where the rate of depreciation is indexed to the inflation differential. The active crawl rule is not stochastic but the depreciation rate is rather determined by discretion. However, a real exchange rate policy, is possibly in conflict with the objective of internal stability.
Domestic inflation is the basic concern. In simple terms, higher exchange rates might feed back on domestic inflation and activate a cycle of devaluation-inflation. Real exchange rate targeting thus implies the loss of a nominal anchor to fight domestic inflation. Especially in the presence of capital mobility, the monetary authority's ability to control money supply (another possible instrument) is limited if any exchange rate target is pursued (Aghevli et al., 1991). 2 In this paper, we make an empirical investigation into the conflict of objectives under real exchange rate targeting by drawing on the Turkish case. The main question we ask is: how are external competitiveness and price stability affected when a real exchange rate policy is adopted? We use a macromodel of exchange rate policy for Turkey, which was applied to quarterly Turkish data for mainly 1980: I -
*We are grateful to anonymous referees of the journal for their helpful comments of the first version of this paper. The usual disclaimer applies. Final revision accepted: April 26, 1997.
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WORLD DEVELOPMENT
1993:4. We hope that the present empirical analysis will be a modest addition to the real exchange rate literature which is predominantly analytical.~More important, we explicitly consider the policy credibility or devaluation expectations under the crawling peg regime. Policy credibility or devaluation expectations are a critical issues as they can substantially modify the consequence of a policy action. Alternative scenarios of credibility for exchange rate policy within the passive and active crawling peg regimes will be specified, and the implications for the trade balance and inflation will be investigated by the help of model simulation. The paper proceeds as follows. Section 2 highlights the relevance of the exchange rate policy in Turkey by reviewing the actual developments. Section 3 includes a model-based empirical analysis of (conflicting) aspects of real exchange rate targeting. Section 4 concludes with policy implications.
2. RELEVANCE OF TURKEY Turkey followed an inward-oriented development strategy, and promoted an import-substituting and domestic demand-led growth during most of the 1960s and 1970s. A high growth performance was achieved, but this inward-oriented strategy culminated in a foreign exchange and debt crisis around 1980. The country was exposed to the foreign exchange crisis several years before the outbreak of international debt crisis. In response, Turkey prompted extensive stabilization policies in the early 1980s, which were followed by a liberalization and adjustment period, to solve the chronic foreign exchange problem.4 Export promotion through attractive real exchange rates was a high priority. As part of these comprehensive stabilizationliberalizationpolicies, a flexible exchange rate regime was adopted in the late 1981. It is based on daily adjustments in the nominal exchange rate and characterizes a passive crawling peg regime. In order to avoid deterioration due to inflation in external competitiveness, as well as to accommodate the public expectations, 5 the nominal exchange rate is continuously depreciated. Adoption of such an (implicit) indexation also reduced the political risk of otherwise occasional maxi-devaluations, and therefore removed devaluation from the political agenda. Between May 1981 and August 1988 the real exchange rate targets were achieved through daily revisions of the instrument, i.e. the nominal exchange rate. The rates thus determined by the central bank were used in foreign exchange operations of banks and non-bank agents. In August 1988 the central bank introduced a system of partial market setting of the official exchange rate. The central bank and the other
participants of the foreign exchange market met at daily sessions of the interbank spot exchange market to determine the nominal rate. At the end of each business day the central bank announced the official exchange rate which was agreed on at the session with the market participants. If necessary, the central bank then intervened by buying or selling in the foreign exchange market to realize the official rate resulting from the session (Asikoglu and Uctum, 1992). It is interesting to note that the introduction of this marketbased determination concurred with and was followed by further capital account and interest rate liberalizations. The central bank influenced the nominal rate either directly by setting the rate or indirectly by supporting the rate emerging from sessions of spot exchange market. Figure 1 presents the behavior of the actual and PPP-based nominal exchange rate indices. 6 Both indices are defined for the TL/US $ rate. The actual and PPP-based nominal exchange rates display the closest behavior during 1983-88. The commitment to the real devaluation policy was firm, resulting in a sustained real devaluation during 1981-84 and a constant real rate over 198588 (Figure 2).7 The foreign exchange constraint was substantially eliminated through the improved exports and non-interest current account in a few years. The Turkish case was considered one of the few successes in the 1980s. Since 1989, however, more real appreciations have been allowed to reduce the pressure particularly on the budget deficit (through debt service) and on domestic inflation.8 The policy makers' concern has gradually shifted from the external competitiveness to the fiscal and price stability. Figure 2 presents the behavior of domestic inflationjointly with that of the real exchange rate index. As revealed by the figure, the correlation between the real exchange rate and inflation is not clear-cut. This may be an indication of a complex association, which may in turn follow from close links between the public finance, domestic financial markets and the balance of payments in the liberalized but less stable economies, such as Turkey. The purchasing power parity (PPP) hypothesis serves as a benchmark theory for a descriptive analysis of the co-movements in prices and exchange rates. Given the managed nominal exchange rate, the question is whether the domestic price level or the inflation rate is determined by the external sector, i.e. which variants holds: the absolute PPP, P = EP*,
or the relative PPP,
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EXCHANGE RATE TARGETING AND INFLATION
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Figure 2. Real exchange rate and inflation rate.
There are several ways of testing the above relationships.9 We base our analysis on stationarity tests. In a flexible exchange rate regime, the time series obtained by taking differences of variables on each sides of the above identifies must be stationary. l° This is also identical with saying that the inflation (or price level) differential and devaluation (or exchange rate) must be integrated of order zero (i.e I(0)). If, for example, the new time series
D i n f l = / b _ E _ ~b, (defined as the difference
between inflation differential and devaluation) is stationary, then the relative PPP parity is said to hold, i.e the depreciation rate is the sole determinant of domestic inflation. Below we present some tests of stationarity by using the Turkish and US prices and the TL/$ exchange rate) ~ The test results based on the levels of prices and exchange rate (relevant for the absolute PPP) are not worth presenting
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WORLD DEVELOPMENT
because unit root and cointegration test statistics had positive signs, indicating strong nonstationarity as well as being incomparable with the critical values. 12 The test results for the relative^PPP,~ which is based on the time series D i n f l = P - E - P * , are as follows: The unit root test for the time series (Dinfl) in the first row yielded a value of (-2.32), which is in absolute terms lower than the critical vale (-2.92) at 5%. Similarly, the Ljung-Box test statistics indicate that the time series is not white noise. Finally, the cointegration test also supports the previous two results by indicating that the inflation differential and exchange rate depreciation cannot be integrated to order zero (t-value -2.01 is smaller than the critical value (-3.46) in absolute terms). The analysis of the time series properties of (Dinfl) reported in Table 1 provides preliminary evidence that at least in the short-run, variables other than world inflation and depreciation affect inflation rates in Turkey. That is, the relative PPP, not to mention its absolute version, does not seem to hold in Turkey.
3. EMPIRICAL ANALYSIS (a) Description of the model Our empirical analysis of real exchange rate targeting is based on a fully-fledged macromodel of the post-liberalized Turkish economy. The model initially developed in Erol (1996) is not restricted to the tradeoff between external competitiveness and inflation, but considers simultaneously the real, fiscal and financial aspects of a real exchange rate policy) 3 The model is applied to quarterly Turkish data comprising mainly the 1980:1-1993:4 period to obtain parameter estimates. The model, divided in the real and financial sector blocks, is based on the following assumptions. The goods prices and the interest rates are less than perfectly flexible. There is imperfect substitution between domestic and foreign goods and assets. The country is a price-taker in international goods markets. There is a crawling peg exchange rate regime, where the rate of devaluation is determined
by the authorities either through a systematic rule (a passive crawl) or at discretion (an active crawl). The final objective in the specification of the goods market is to determine the demand and supply-side pressures on domestic inflation. The analysis of the goods market is based on the simplest open economy setting, where there are two final goods, one composite domestic good and one composite foreign good. Private consumption, private investments, exports and imports are the behavioral functions. The real side also includes the functions which determine the (supply of) capacity output and domestic inflation. The financial part of the model describes the non-bank private sector portfolio balance and the equilibrium in the domestic financial system which is represented by the banking sector. The focus is on the specification of the non-bank private sector asset choice, and of the equilibrium in the domestic loans market. A simple open economy portfolio balance model where asset demands are expressed as a share of total assets is utilized to explain the private sector portfolio choice. It is assumed that domestic banks operate under oligopolistic market conditions and set the lending rate. The stock of bank credits is determined by the demand side, The interest part of the budget deficit and government financing identity are also defined in this block. The financial sector is designed in a way that the implications of alternative rules for the nominal devaluation and different modes of deficit finance can be examined. We now focus on the specification of the inflation equation, a key variable. The other equations of the model in estimated form are given in the appendix. The adjustment in the goods market is based on the disequilibrium notion of an open economy as introduced by Dornbusch (1976). The original Dornbusch specification is modified by explicitly specifying expectations regarding the general price inflation (see van Wijnbergen, 1986). Inclusion of the expected inflation enables us to incorporate directly the effect of the exchange rate expectations on domestic inflation under real exchange rate targeting.
Table 1. Stationarity tests on the relative PPP in Turkey, 1980.1-1993.4 Name of test Unit root White noise Engle-Granger Cointegration
Test statistics
t-values
Critical value at 5%
Augmented Dickey-Fuller a Ljung-Box with Q(8)c Augmented Dickey-Fuller a
-2.32 b 3.76 (0.43)d
-2.92b
-2.018
-3.46
aBased on 4 lags. bAn intercept term is included in the regression. °With 8 degrees of freedom. dFigure in parenthesis gives the probability that the series is whitenoise.
EXCHANGE RATE TARGETING AND INFLATION In its basic form, the inflation rate (/5) then depends on the demand pressure as represented by the ratio between actual and capacity output (~) and on the expected general inflation rate (~e).
We define two relevant production functions, one corresponding to the actual demand-determined output (y) and other to the capacity output (~). Furthermore, we adopt a simple one-factor production function, where output is proportional to the capital stock and the capital-output ratio (p). Recalling that output is demand-determined (equation 6 in the appendix), the production function for (y) then determines the relevant capital stock (K). A simple capital accumulation rule is used to define the installed capacity or actual capital stock (R'). Through simple substitution the demand pressure is finally expressed as the (K) ratio, which provides a measure of capacity utilization. Finally, we define the index for the expected general inflation to substitute (g~) out,
where, the rate of change in general prices is given as an average index of the rate of change in domestic and foreign good§ prices. The rate of change in domestic prices (P) is consequently expressed as a function of the capacit2 utilization rate (~), the expected devaluation (E e) and foreign inflation (P*~), and the lagged dependent variable (/5 I) to account for inertial part of inflation. K k = :&o + 351 ( } ) + d~2/~ e + ,~s3b ,~ +,~54b L ~51 • 0, ~52 > 0, ,~53 > 0, 0 < :954 < l
(la)
where, ~51 = A/(1 - 3~) is obtained by substituting for (~). To the extent that the crawling peg (which is an ingredient of the real exchange rate targeting) functions like a flexible exchange regime it is the exchange rate which is primarily influenced by money creation. Therefore, the monetary financeinflation spiral is weakened, and the exchange rate becomes the main transmission channel (see Kamas, 1995). The complete model, which consists of 21 endogenous variables 14 (11 behavioral equations and l0 identities), is applied to quarterly Turkish data mainly for the 1980:1-1993:4 sample period. Some major observations from estimation on the real
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sector equations are as follows (see the appendix for the complete parameter estimates): -relatively high real exchange rate elasticities are found in the import and export demand functions. - - these elasticities are also large in the consumption and investment demand functions; - - a J-curve effect is observed in the export function; 15 and - - domestic inflation is very flexible in Turkey, i.e. it adjusts very quickly or it is not inertial.
(b) Simulation experiment.s" In this section we first examine the consequences of adopting a constant real exchange rate rule based on the relative PPP, where the devaluation rate is fully indexed to the price differential. We ask what would have happened if such a rule had been adopted? Next we deal with the issue of policy credibility. The relative PPP rule with information lag is given by
t2 = (/' - ,a,) ,, where/~ is the rate of crawl, and /5 and/5* are the domestic and foreign inflation rates. We compare the simulation results based on this rule with baseline simulations where the crawl is exogenous] 6 We run the simulation for the 1985:1-93:4 period. The differences in real output, inflation, and the trade deficit-output ratio from the baseline simulation are presented in Figure 3. If the relative PPP rule had been adopted between 1985:1-1993:4 it would, on average, have resulted in: - - a higher domestic output (by 3.19%); - - a significant improvement in the trade deficit (the deficit-output ratio drops from 2.18 to 1.02%);
- - a negligible increase in domestic inflation (by 0.24 percentage points). These results are an indication that the relative PPP rule, compared to the baseline situation, is in general superior: significant improvements in domestic output and the trade balance outweigh a negligible rise in domestic inflation. In this subsection we examine the role of policy credibility or devaluation expectations in real exchange rate targeting. We deal with this issue by explicitly specifying alternative scenarios for policy credibility and incorporating them into the simulation model. Before concentrating on the specification of alternative credibility cases, we first discuss the relevance of the issue in Turkey. As previously mentioned, the policy makers'
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WORLD DEVELOPMENT IO.O -
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Figure 3. Output, inflation, and trade deficit-output ratio (difference from baseline in percentage). concern has gradually shifted from the external competitiveness to the internal stability, especially to the fiscal and price stability. The real devaluation policy has been slowed down to reduce the pressure on the government budget and inflation. In consequence, the exchange rate devaluation has been lower, resulting sometimes in a real appreciation, This has particularly alleviated the foreign debt service pressure on the government budget. Given the highly liberalized foreign exchange regime and external capital account, however, the relief through lower devaluation on the fiscal balance could not be permanent. Lower devaluation can only be realized by a continuous rise in the domestic interest rates. Under capital mobility, intentionally lower exchange rates can only be achieved at the expense of higher domestic interest rates (which must compensate for the expected devaluation). In the end, the pressure from foreign debt service is temporarily reduced at the expense of domestic debt service. A financial crisis which originates in the foreign exchange markets and spreads to the rest of domestic financial system will also probably accompany. Recently, Turkey survived from a so-called confidence crisis which occurred in early 1994. This is an appropriate place to emphasize the changing pattern of the foreign exchange problem in Turkey. In the late 1970s and early 1980s, the foreign exchange crises originated basically in the current account and undermined the capacity to import (i.e. a real foreign exchange constraint). In contrast, the recent confidence crisis originated mainly in the domestic foreign exchange market, enhanced through the
capital account, and they threatened the stability of domestic financial system. By this we do not mean, however, that the deterioration in the current account had no role in the recent foreign exchange crisis. It did have a role but only gradually due to the accumulated current deficit. Although the exchange rate regime is a highly flexible crawling peg, maxi-devaluations were necessary to get out of the confidence crisis. Figure 4, which plots the devaluation rate along with the interest rate differential (a proxy for the expected devaluation), is very illustrative. Mid-1985 is a dividing line. Beforehand, the interest rate differential stayed below the actual devaluation, while afterwards it exceeded the actual devaluation, except two occasions of maxi-devaluations. We now concentrate on the policy credibility under crawling peg regime. We distinguish two policy regimes: the passive (flexible) and the active (fixed) crawling pegs. In the passive crawl, the devaluation is indexed to some economic variables that are not usually under the (direct) control of authorities. A usual example is the relative purchasing power parity, which we have just applied. In the active crawl, the indexation of the exchange rate depreciation is abandoned, i.e, it is fixed. Here the priority is to fight domestic inflation rather than to increase the external competitiveness. The policy can be incorporated in two ways. The crawl can either be set to zero or it can be fixed to (a basket of) foreign currencies. We prefer to use the former for its simplicity. It implies that the exchange rate is fixed at its initial level. Policy credibility impinges on the expected rate of
EXCHANGE RATE TARGETING AND INFLATION
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Figure 4. Exchange rate depreciation and interest rate differential. devaluation or the expected crawl ~e. The policy is said to be credible if it is consistent with the public' s expectations. In this case, the regime is perceived as sustainable, i.e. has not to be reversed soon. The result of non-credibility is, however, a speculative run on the domestic banks and foreign exchange reserves, a crisis in the domestic banking system, and the abandonment of the regime. Two polar cases of credibility relevant for the fixed regime are identified. A fully credible and a noncredible (confidence crisis) case. The f u l l credibility characterizes the situation when the public expectations are consistent with the fixed regime which sets the actual crawl. That is, the actual and expected rate of devaluation are identical,
Where, it) and io are the domestic and foreign deposit interest rates per quarter. We consider only the fully credible case for the passive crawl, where the crawl is governed by the relative PPP and is identical with the expected devaluation. This perfect foresight specification, which was actually adopted above, is consistent with the passively crawling regime. It is argued that the actual rate of devaluation is a good predictor of the expected devaluation in the presence of passive crawl (see del Castillo, 1992).17 The simulation path corresponding to the passive crawling peg regime is denoted by S I M 1 . The simulation paths corresponding to the fully credible and non-credible cases of the fixed regime are respectively denoted by S I M F I X 1 and S I M F I X 2 . To repeat, the three simulated paths displayed in the graphs and the governing rules are,
The c o n f i d e n c e crisis emerges when the public expectations are inconsistent with the fixed regime. That is, the actual and expected rate of devaluation are different,
SIM1
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= = (/" -- /-'*)-1 (fully credible flexible regime, the relative PPP)
SIMFIXI
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SIMFIX2
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credible fixed regime) In this c a s e the divergent rate of the expected devaluation E e needs to be specified. We have two alternatives. It can be set either to the inflation differential (through the relative PPP) or to the interest rate differential (through the uncovered interest parity, UIP). We have chosen the latter, giving E~ = ( io - io*)_1
The deviations of domestic output, the trade balance-output ratio, and domestic inflation from their baseline values are represented below. ~s (See Figures 5-7). Fixing the nominal exchange rate under the full credibility and non-credibility scenarios has the following consequences in comparison to the baseline simulation:
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WORLD DEVELOPMENT 15
a loss of 4.48% and 8.16% in real output under respectively the fully credible and non-credible cases; - - an increase of 2.83 and 5.79 percentage points in the trade deficit-output ratio under respectively the full credibility and non-credibility; - - a decline of 4.65 percentage points in domestic inflation under the full credibility and a 1.59 percentage points increase under the non-credibility. 19
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4. POLICY CONCLUSIONS
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The main policy conclusions, based on the simulation experiments, can be summarized as follows. A devaluation (indexation) rule based on the relative PPP, a constant real exchange rate targeting, seems to be superior to the policy actually implemented because it would have led to - - higher growth, -- lower trade deficit-output ratio, -- moderate pressure on domestic inflation. This also means that a real exchange rate appreciation has a contractionary effect on domestic output in Turkey, which is a characteristic of the demand-determined output case. On average, a 3.19% higher real growth might have been achieved over 1985-93 if a constant real exchange rate policy (via the relative PPP rule) had been adopted. Moreover, a well-defined rule might have an additional beneficial effect by eliminating uncertainty. In this respect, the 1994 confidence crisis, which originated in the domestic foreign exchange market and undermined the stability of the domestic financial system, is noteworthy. This crisis can be seen as an accumulated effect of a lower devaluation policy which lacked a clear rule. The crisis might have been avoided if the relative PPP had been followed: the simulation experiment based on this rule indicated a 30% overvaluation by the end of
Real output (in percentage deviation from baseline).
1993, which is roughly the same amount as the actual devaluation undertaken in January and February 1994 to overcome the crisis. Furthermore, it might have contributed to the stability of the goods market by providing correct information on the likely evolution of relative prices. The real exchange rate depreciation tends to improve the trade balance but in an unstable way due to the J-curve effect in the export function (which is a quarter with an elasticity of 28%). The implication of the J-curve effect is that the improvement in the trade balance, a key target in the exchange rate management, will not be stable. In short, the trade balance improvement through real exchange rate targeting is possible but it seems destabilizing in nature. If the priority is to reduce domestic inflation, a fixed (or predetermined) exchange rate policy is the option. Reduction in inflation is, of course, bought especially by lower output and a higher trade deficit. The reduction in inflation can only be achieved, however, if the public perceives the fixed regime as credible or sustainable. Credibility requires that the public expects no (or an equal devaluation when it is predetermined) devaluation. If the fixed exchange rate policy lacks credibility the results are detrimental: drastic deterioration in real output and the
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EXCHANGE RATE TARGETING AND INFLATION
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Figure 7. Domestic inflation (difference from baseline in percentage). trade balance is n o w c o m b i n e d with a higher inflation. Establishing f o r w a r d (futures) e x c h a n g e rate markets in the domestic e c o n o m y may help to hedge the risk (and to reduce the cost) o f foreign exchange transactions and therefore the speculative part o f the exchange rate depreciation. As a result, the indexation (of actual devaluation) can be lowered without endangering the credibility. Second, the forward markets can serve as a guide for the g o v e r n m e n t in the exchange rate management: forward rates can provide a first hand information about the expected devaluation and thus help to avoid confidence crisis. A final point concerns a r e n e w e d policy debate in
Turkey on restoring confidence in the domestic currency, the Lira. It is proposed that several digits be dropped from the lira in order both to simplify accounting and increase the purchasing p o w e r (and consequently the store o f value) o f the domestic currency. Such a basically accounting operation should be a part o f a more extensive stabilization package whose ultimate aim is to regain price stability (i.e. to stabilize inflation at an reasonable low rate). The package may involve price freezes, including the e x c h a n g e rate, g o o d s prices and 20 interest rates. As verified in the model simulations, however, a prerequisitive for the achievement o f this goal is that the package be credible.
NOTES 1. Although there are other policies to attain a given real exchange rate, the nominal exchange rate is preferred because it is usually more flexible to manage and has a more direct effect on the real exchange rate. But the real exchange rate has not been the only real target used by the authorities. A real interest rate target (inflation-indexed nominal interest rate) on government securities, called as TEFE+, where TEFE denotes the inflation rate based on WPI, has also been used in Turkey.
able. Consequently, a common expectation among both general public and exporters has emerged: the depreciation will closely follow the domestic inflation rate.
2. This dos not mean that real exchange rate targeting necessarily leads to price indeterminacy.
7. The real exchange rate is computed as: RER=EP*/P, where (P) and (P*) are, as before, the WPIs of Turkey and the United States, and E is the index of official nominal exchange rate (TL per US $). A rise in the index means a real depreciation while a decline means a real appreciation.
3. A most recent review is provided in Calvo et al. (1995). Other relevant studies are Dornbusch (1992), Adams and Gros (1986), Lizondo (1991), Lizondo (1993), Montiel and Ostry (1991)Montiel and Ostry (1992). Similar issues were earlier discussed in Williamson (1981) in the context of Latin America. 4. In the same period, an extensive deregulation of domestic interest rates, goods prices and the foreign exchange regime took place. 5. The environment in which exchange rate expectations are formed is worth noting. The role of the exchange rate depreciation in export promotion has been unquestion-
6. The PPP exchange rate was computed as the ratio of domestic WPI to that of United States. The actual nominal exchange rate is the average of buying and selling rates at the inter-bank spot exchange market.
8. The trend behavior of the real exchange rate is consistent with the progress of the Turkish economy and alone can represent the cycles or the phases in the economy. The first period corresponds to the most successful phase, in which there was an export boom, decline in inflation and budget deficit, etc. In the second period there was a stability in exports, and inflation and budget deficit revived a bit. The last period corresponds to a deterioration in exports, inflation and budget deficits due to both rising political tension (frequent elections) and loose policy measures (especially lower nominal exchange rate depreciations).
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WORLD DEVELOPMENT
9. See, e.g., Dornbusch and Giovannini (1990) for alternative ways of testing the PPP relationships.
15. We did not attempt to provide detailed theoretical explanation for this result. See Bahmani-Oskooee and Malixi (1992) and Domac (1993) for this purpose.
10. In a fixed regime, the exchange rate variable is assumed to be constant and can be left out (see Edwards, 1993).
16. In addition, other policy variables (e.g., ratios alternative deficit finance) are also set to their actual level in the baseline simulation.
11. As noted before, the US price represents the world price, and the wholesale prices are used in every case.
17. We have also experimented with an alternative, i.e. less than fully credible version of the relative PPP rule by setting the expected devaluation to the interest rate differential. The results, whose divergence from the baseline simulation is negligible compared to those of the fixed regime, are not presented here because four curves on the same graph distort the visual inspection.
12. Logarithmic forms of the price level variables were used. 13. In the original model we are concerned with the tradeoff between internal stability and external competitiveness. Internal stability as defined there also includes the fiscal (mainly interest part of the budget) and financial stability (currency substitution or dollarization), as well as the price stability.
19. Note that this increase occurs when the exchange rate (which explains 36% of inflation) is fixed, i.e., when there is no feedback from the devaluation.
14. Note that this is the core model where the rule for exchange rate policy is not yet included.
20. These are of course short-term measures that pave the way for a viable solution, which requires especially the correction of fiscal imbalance.
18.
The simulation period is 1992.1-1993.3.
REFERENCES Aghevli, B., Bijan, M., Khan, S. and Montiel, P. J. (1991) Exchange rate policy in developing countries: some analytical issues, Occasional Papers, no. 78. International Monetary Fund, Washingon DC. Adams, C. and Gros, D. (1986) The consequences of real exchange rate rules for inflation: some illustrative examples. IMF Staff Papers 33(2), 439-476. Asikoglu, Y. and Uctum, M. (1992) A critical evaluation of exchange rate policy in Turkey. World Development
20(10). Bahmani-Oskooee, M. and Malixi, M. (1992) More evidence on the J-curve from LDCs. Journal of Policy Modelling (October, 1992). Calvo, A. G., Reinhart, C. M. and V6gh, C. A. (1995) Targeting the real exchange rate: theory and evidence. Journal of Development Economics 47(1), 97-133. del Castillo, G. (1992) Policy fundamentals, interest rate differential, and expected devaluation in the presence of an active crawling peg system. Journal of International Money and Finance 11(2), 292-303. Domac, I. (1993) The J-curve phenomenon and its existence in Turkey, Yapi Kredi Economic Review Vol. 6, January 1993. Yapi Kredi Bank, Istanbul. Dornbusch, R. (1976) Expectations and exchange rate dynamics. Journal of Political Economy 84(6), 11611176. Dornbusch, R. (1992) PPP exchange rate rules and macroeconomic stability. Journal of Political Economy 90(i), 158-165. Dornbusch, R. and Giovannini, A. (1990) Monetary policy in the open economy. In Handbook of Monetary
Economics, ed. B. M. Friedman and F. H. Hahn, Vol. II. North Holland, Amsterdam. Edwards, S. (1993) Exchange rates, inflation and disinflation: Latin American experiences, Working Papers, No. 4320. National Bureau of Economic Research, Cmabridge, MA. Erol, T. (1996) Exchange rate policy in Turkey: External competitiveness and internal stability, 1980-1993, Research Series No. 113. Tinbergen Institute, Rotterdam, The Netherlands. Kamas, L. (1995) Monetary policy and inflation under the crawling peg: some evidence from VARSs for Colombia. Journal of Development Economics 46(1), 145-161. Lizondo, J. S. (1991) Real exchange rate target, nominal exchange rate policies, and inflation. Revista de Analisis Economico 6(1), 5-21. Lizondo, J. S. (1993) Real exchange rate targeting under imperfect asset substitutability, Working Papers, No. 93/ 38. International Monetary Fund, Washington DC. Montiel, P. J. and Ostry, J. D. (1991) Macroeconomic implications of exchange rate targeting in developing countries. IMF Staff Papers 38(4), 872-900. Montiel, P. J. and Ostry, J. D. (1992) Real exchange rate targeting under capital control: can money provide a nominal anchor. IMF Staff Papers 39(1), 59-78. van Wijnbergen, S. (1986) Exchange rate management and stabilization policies in developing countries. Journal of Development Economics 23(2), 227-247. Williamson, J. (1981) Exchange Rate Rules: Theory, Performance and Prospects of the Crawling Peg, ed. J. Williamson. Macmillan, London.
EXCHANGE RATE TARGETING AND INFLATION
1727
APPENDIX A: THE EMPIRICAL MODEL W I T H P A R A M E T E R ESTIMATES (a) Domestic price inflation p
=
(g) Installed fixed capital stock
0.08 + 0.36E + 0.11/b~
-
+ 0.21CAPUTLP + O.03SEAS1
R = R-I (1 - 6) + invp + invg (Al) (h) Utilized fixed capital stock
- O.04SEAS3 + 0.002P_I K = py (b)
(A7)
(A8)
Real private consumption demand
log(consp) =
(i) Nominal budget deficit
1.52 - 0.13(isR) - O.151og(EoP*/P) + 0.791og(y - tax)
(a2)
DEFG = (CONSG + INVG - TAX)
(A9) + O.04SEAS3 + O.031og(consp)_4
(c) Real private investment demand
+ INTD + INTF
(j) Government interest payments on domestic debt
log(invp) = - 4 . 4 5 + 6.281og(1 + CAPUTLP)
INTD = 0.333(LOANG + LOANG_~
(AI0)
+ 0.351og(y) - 0.40log(1 + i~)
+ LOANG_2)iL
(A3) + 0.261og (EoP~/P) - O.05SEASI
(k) Government interest payments on foreign debt
+ O.02SEAS2 + 0.461og(invp)_4
INTF = 0.333(FLOANG + FLOANG_~
(d) Export demand at constant domestic prices + FLOANG_2)0.333 log(expo) = - 1.93 + .281og(EoP*JP)_l
(A 11 )
(i~ + i~_ l + i~_2)
+ O. 151og(oecdimp) + O.05SEAS3
(1) Private sector asset demands (A4)
-
0.26SEAS4 + 1.991og
CUR W
(1 + CAPUTLP)
-
0.0163 - 0.0543isR - 0.1319i~ - 0.0144i~: - 0.2304P
+ 0.361og(expo)_ 1
(A12) + 0 . 3 0 4 6 ( ~ ) - O.O004TIME3
(e) Import demand at constant domestic prices
+ 0.1776(-~)_, log(impo) = 2.79 - 0.601og(EoP*m/P) + 0.29log(absorb) - O. 18SEAS1 (A5)
SDEP
-
0.1083 + 0.3252i~ - 0.3293i~
W
+ O.12SEAS4 + 0.511og(impo)_ l -
0.0869iRF -- 0.2131 (---W) (AI3)
(f) Real domestic output
- O.O187SEAS1 - 0.0139SEAS4
y = consp + consg + invp + invg
(A6) + expo - impo
0 4412
+
.
SDEP (--if--)_,
1728
WORLD DEVELOPMENT
TDEP
(p) Residual financial asset in the private sector
= 0.1723 - 0.3381i~ + 0.2774i~
portfolio
W -
O.O013TIME3 - 0.0186SEAS3
(A14)
TDEP
+ AErDEP* + i~(CUR/P)
• -0.0233SEAS4 ÷ 0.6392( _--zz7-_.) ~ ~
FDEP
W
~
(a19)
= 0.0093 - 0.1427isR + 0.1543i~
Wre~ = W - CUR - SDEP - TDEP - FDEP (A20)
W
- 0 . 0 6 1 3 ( 1 ) + O010TIME2 -
AVp = (y -- consp -- invp)P - TAX + iLLOANG
(AI5) (q) Government financing identity (which determines the supply o f central bank credit to the government)
0.0093SEAS2 + 0 . 9 5 5 0 ( ~ - ~ ) _ ~
A D C = DEFG - A L O A N G + A F L O A N G
(A21)
(m) Real interest rate on domestic loans (credits) i~ --
(r) Classification o f variables
- 0.09 + 0.64i~i s + 0.27i~ + 0.54LOANSP_ ~
(A 16)
+ 0.30LOANSG_I ~+ 0.30i~-1
(n) Private sector demand for domestic loans (credits) LOANP -
INVP
-
(A17) 0 2
LOANP
. 6(~)_,
-
LOANP
(s) Explanations about the notations for symbols and operators
(o) Private sector balance sheet and budget constraints w
Exogenous variables: CONSG, INVG, WAGE; LOANG, FLOANG, E, E, is, iT, iD*, iL*, Px*, Pro*, p.n. Exogenous parameters: 5: amortization rate of fixed capital stock (=0.025), p: capital-output ratio (=2).
- 0.02 - 0.40i~ + 0.27i~* + 0.10(/--~) +
Vp =
21 endoge~nous variables: consp, invp, expo, impo, y, K, [(~, DEFG; P, iR; CUR/W, SDEP/~, TDEP/W, FDEP/W, Vp, W, Wres, LOANP/1NVP, DC; IND, INTF.
(A18)
- - Upper case symbols mostly refer to nominal variables (exceptions are the fixed capital stock and wage rate) while lower case symbols refer to real variables, ^ (above a variable) refers to rate of change,* (above a variable) refers to a foreign variableA (before a variable) refers to change.
EXCHANGE RATE TARGETING AND INFLATION
(t) Alphabetic list of all variables used
CAPUTLP consp CONSG CUR
capacity utilization rate in the private sector real private consumption public sector consumption at current prices household demand for domestic currency (nominal) DC central bank credit to the government (nominal) DEFG budget deficit (nominal) SDEP domestic short-term (demand) deposits (nominal) nominal foreign exchange rate and its rate of change FDEP foreign exchange deposits in domestic currency FLOANG foreign borrowing by the government in domestic currency is,i~ nominal and real interest rate on domestic short-term deposits iT,i~ nominal and real interest rate on domestic time deposits nominal foreign interest rates on foreign iD*,iL* deposits and loans it,, iL R nominal and real interest rate on domestic bank loans impo real total imports INTD government interest payments on domestic debt (nominal) INTF government interest payments on foreign debt (nominal)
invp INVG g
K LOANP LOANG oecflimp p, p Px*, Pm* Pn*
RES SEAS~ TAX TDEP WAGE Vp W
Wres Y Y y,
1729
real private investment public sector investment at current prices stock of actually utilized fixed capital (real) installed fixed capital stock (real) private sector demand for domestic credits (nominal) public sector demand for domestic credits (nominal) volume of OECD real import (index) domestic price index and inflation rate foreign currency prices of export and imported consumer goods foreign currency prices imported capital goods total domestic reserves of the banks at the central bank seasonal dummies government total revenues from taxes and other means (nominal) private sector time deposits (nominal) real wage rate in the private sector, nominal (TL per day) index deflated by CPI non-bank private sector net worth total private financial assets (nominal) residual financial asset in the private sector portfolio real domestic output (demand-determined) capacity output real foreign income
A P P E N D I X B: D A T A S O U R C E S (a) Bank deposits and currency (SDEP, TDEP,
(e) Interest rate on foreign borrowing (i'L)
FDEP, CUR) Source: IFS (International Financial Statistics) for 1980.01-1985.12; CBTUR (Central Bank of Turkey, 1993) for 1986.01-1991.12. CBTUR (1993) is a special issue of monthly money and banking statistics for 1986.011991.12; CBTUR Quarterly Bulletins for 1992.01-1993.12.
Source: World Debt Tables, various issues, The World Bank.
(f) Foreign exchange rate (TL per $: E=TL/$) Source: CBTUR, Quarterly Bulletins.
(b) Domestic borrowings (DC, LOANP, LOANG) Source: same as financial assets above.
(g) Interest payments by the public sector (INTD and INTF) Source: Under-Secretary of Treasury.
(c) Public sector foreign borrowing (FLOANG) (h) Turkish and US domestic price indexes (Pd, P,~) Source: Under-Secretary of Treasury and Foreign Trade. Source: OECD (monthly) Main Indicators on Economics
Mainstream Data Disks. (d) Interest rate on bank deposits and loans (is, it, t D,IL) Source: CBTUR Monthly and Quarterly Bulletins.
(i) Foreign price indices (P~, P~, Pn*) Source: CBTUR, Quarterly Bulletins.
1730
WORLD DEVELOPMENT
(j) Components of GDP (CONSPC, CONSGC, INVPC, INVGC, EXPOTL, IMPOTL)
92, and the 1993 values were calculated from an accumulation equation assuming 2.5% depreciation per annum.
Source: Ozmucur [A quarterly econometric model of Turkey, 1987, TUSIAD] for 1980.1-1986.4, and various News Bulletins of the State Institute of Statistics (ISS) for 1987.1-1993.4. (1) Capacity utilization rate (CAPUTLP) (k) Stock of fixed capital (K) Source: State Planning Organization (SPO) for 1979-
Source: Statistics Yearbooks of the State Institute of Statistics (ISS).
Pergamon PII: SO305-750X(97)O0061-2
Real Exchange Rate Targeting and Inflation in Turkey" An Empirical Analysis with Policy Credibility TURAN
EROL
Erasmus University and Tinbergen Institute, Rotterdam, The Netherlands and SWEDER
VAN
WIJNBERGEN*
University o f Amsterdam, The Netherlands Summary. - - In this paper we make an empirical investigation into the conflict among objectives under a real exchange rate policy, i.e. between the trade balance and domestic inflation. This occurs when the nominal exchange rate is managed to achieve a certain level of the real exchange rate in order to main external competitiveness. Our empirical analysis draws on the Turkish case, whereby the exchange rate has been the key policy instrument since the 1980s. The results from the simulation experiments with a well-defined macromodel, where the devaluation expectations are explicitly considered, indicate moderate inflationary consequences of a real exchange rate policy based on the relative purchasing power parity (PPP) rule in Turkey. Moreover, a real exchange rate appreciation is found to be contractionary. These are common characteristics of the demand-determined output case. Another major conclusion is that the exchange rate policy can provide an anchor for price stability only if it is credible. © 1997 Elsevier Science Ltd
Key words -- real exchange rates, inflation, policy credibility, Turkey
1. INTRODUCTION In inflation-prone countries authorities engage in real exchange rate targeting by managing the nominal exchange rate. The aim is to maintain international competitiveness through realistic real exchange rates. Better trade and capital account balances are in turn essential to finance the often high existing official foreign debt. Under these conditions, the real exchange rate, a key relative price in any open economy, usually proves to be the most popular real target. l The underlying exchange rate system is usually a passive or active crawling peg regime. The policy rule governing the passive crawl is stochastic because it is linked to the behavior of other economic variables within the system. Relative purchasing power parity (PPP) is the most commonly adopted passive crawl rule, where the rate of depreciation is indexed to the inflation differential. The active crawl rule is not stochastic but the depreciation rate is rather determined by discretion. However, a real exchange rate policy, is possibly in conflict with the objective of internal stability.
Domestic inflation is the basic concern. In simple terms, higher exchange rates might feed back on domestic inflation and activate a cycle of devaluation-inflation. Real exchange rate targeting thus implies the loss of a nominal anchor to fight domestic inflation. Especially in the presence of capital mobility, the monetary authority's ability to control money supply (another possible instrument) is limited if any exchange rate target is pursued (Aghevli et al., 1991). 2 In this paper, we make an empirical investigation into the conflict of objectives under real exchange rate targeting by drawing on the Turkish case. The main question we ask is: how are external competitiveness and price stability affected when a real exchange rate policy is adopted? We use a macromodel of exchange rate policy for Turkey, which was applied to quarterly Turkish data for mainly 1980: I -
*We are grateful to anonymous referees of the journal for their helpful comments of the first version of this paper. The usual disclaimer applies. Final revision accepted: April 26, 1997.
1717
1718
WORLD DEVELOPMENT
1993:4. We hope that the present empirical analysis will be a modest addition to the real exchange rate literature which is predominantly analytical.~More important, we explicitly consider the policy credibility or devaluation expectations under the crawling peg regime. Policy credibility or devaluation expectations are a critical issues as they can substantially modify the consequence of a policy action. Alternative scenarios of credibility for exchange rate policy within the passive and active crawling peg regimes will be specified, and the implications for the trade balance and inflation will be investigated by the help of model simulation. The paper proceeds as follows. Section 2 highlights the relevance of the exchange rate policy in Turkey by reviewing the actual developments. Section 3 includes a model-based empirical analysis of (conflicting) aspects of real exchange rate targeting. Section 4 concludes with policy implications.
2. RELEVANCE OF TURKEY Turkey followed an inward-oriented development strategy, and promoted an import-substituting and domestic demand-led growth during most of the 1960s and 1970s. A high growth performance was achieved, but this inward-oriented strategy culminated in a foreign exchange and debt crisis around 1980. The country was exposed to the foreign exchange crisis several years before the outbreak of international debt crisis. In response, Turkey prompted extensive stabilization policies in the early 1980s, which were followed by a liberalization and adjustment period, to solve the chronic foreign exchange problem.4 Export promotion through attractive real exchange rates was a high priority. As part of these comprehensive stabilizationliberalizationpolicies, a flexible exchange rate regime was adopted in the late 1981. It is based on daily adjustments in the nominal exchange rate and characterizes a passive crawling peg regime. In order to avoid deterioration due to inflation in external competitiveness, as well as to accommodate the public expectations, 5 the nominal exchange rate is continuously depreciated. Adoption of such an (implicit) indexation also reduced the political risk of otherwise occasional maxi-devaluations, and therefore removed devaluation from the political agenda. Between May 1981 and August 1988 the real exchange rate targets were achieved through daily revisions of the instrument, i.e. the nominal exchange rate. The rates thus determined by the central bank were used in foreign exchange operations of banks and non-bank agents. In August 1988 the central bank introduced a system of partial market setting of the official exchange rate. The central bank and the other
participants of the foreign exchange market met at daily sessions of the interbank spot exchange market to determine the nominal rate. At the end of each business day the central bank announced the official exchange rate which was agreed on at the session with the market participants. If necessary, the central bank then intervened by buying or selling in the foreign exchange market to realize the official rate resulting from the session (Asikoglu and Uctum, 1992). It is interesting to note that the introduction of this marketbased determination concurred with and was followed by further capital account and interest rate liberalizations. The central bank influenced the nominal rate either directly by setting the rate or indirectly by supporting the rate emerging from sessions of spot exchange market. Figure 1 presents the behavior of the actual and PPP-based nominal exchange rate indices. 6 Both indices are defined for the TL/US $ rate. The actual and PPP-based nominal exchange rates display the closest behavior during 1983-88. The commitment to the real devaluation policy was firm, resulting in a sustained real devaluation during 1981-84 and a constant real rate over 198588 (Figure 2).7 The foreign exchange constraint was substantially eliminated through the improved exports and non-interest current account in a few years. The Turkish case was considered one of the few successes in the 1980s. Since 1989, however, more real appreciations have been allowed to reduce the pressure particularly on the budget deficit (through debt service) and on domestic inflation.8 The policy makers' concern has gradually shifted from the external competitiveness to the fiscal and price stability. Figure 2 presents the behavior of domestic inflationjointly with that of the real exchange rate index. As revealed by the figure, the correlation between the real exchange rate and inflation is not clear-cut. This may be an indication of a complex association, which may in turn follow from close links between the public finance, domestic financial markets and the balance of payments in the liberalized but less stable economies, such as Turkey. The purchasing power parity (PPP) hypothesis serves as a benchmark theory for a descriptive analysis of the co-movements in prices and exchange rates. Given the managed nominal exchange rate, the question is whether the domestic price level or the inflation rate is determined by the external sector, i.e. which variants holds: the absolute PPP, P = EP*,
or the relative PPP,
/~=~+~*.
EXCHANGE RATE TARGETING AND INFLATION
1719
8 -
/
J
6 --
o
rate
5 -
4
3
2 80
I
I
I
I
l
I
I
I
I
I
I
I
1
81
82
83
84
85
86
87
88
89
90
91
92
93
Figure 1. Actual and PPP-based nominal exchange rate indices (1985.4=100).
170
0.30
Real exchange rate (left scale)
160 150 O
¥ ~5
oc
-
^"W~
0.25
t'-"
-
0.20 140 0.15
130 120
e.~ e-
0.10 I
110 ,
100
,it./,
]i/t
~N/]
90 8O
Inflation rate (~ight scale)
l
L
81
82
83
i],
/
tl
~1
~
i
t
I
I
I
I
t
I
I
I
I
84
85
86
87
88
89
90
91
92
i
93
0.05
0,00
Figure 2. Real exchange rate and inflation rate.
There are several ways of testing the above relationships.9 We base our analysis on stationarity tests. In a flexible exchange rate regime, the time series obtained by taking differences of variables on each sides of the above identifies must be stationary. l° This is also identical with saying that the inflation (or price level) differential and devaluation (or exchange rate) must be integrated of order zero (i.e I(0)). If, for example, the new time series
D i n f l = / b _ E _ ~b, (defined as the difference
between inflation differential and devaluation) is stationary, then the relative PPP parity is said to hold, i.e the depreciation rate is the sole determinant of domestic inflation. Below we present some tests of stationarity by using the Turkish and US prices and the TL/$ exchange rate) ~ The test results based on the levels of prices and exchange rate (relevant for the absolute PPP) are not worth presenting
1720
WORLD DEVELOPMENT
because unit root and cointegration test statistics had positive signs, indicating strong nonstationarity as well as being incomparable with the critical values. 12 The test results for the relative^PPP,~ which is based on the time series D i n f l = P - E - P * , are as follows: The unit root test for the time series (Dinfl) in the first row yielded a value of (-2.32), which is in absolute terms lower than the critical vale (-2.92) at 5%. Similarly, the Ljung-Box test statistics indicate that the time series is not white noise. Finally, the cointegration test also supports the previous two results by indicating that the inflation differential and exchange rate depreciation cannot be integrated to order zero (t-value -2.01 is smaller than the critical value (-3.46) in absolute terms). The analysis of the time series properties of (Dinfl) reported in Table 1 provides preliminary evidence that at least in the short-run, variables other than world inflation and depreciation affect inflation rates in Turkey. That is, the relative PPP, not to mention its absolute version, does not seem to hold in Turkey.
3. EMPIRICAL ANALYSIS (a) Description of the model Our empirical analysis of real exchange rate targeting is based on a fully-fledged macromodel of the post-liberalized Turkish economy. The model initially developed in Erol (1996) is not restricted to the tradeoff between external competitiveness and inflation, but considers simultaneously the real, fiscal and financial aspects of a real exchange rate policy) 3 The model is applied to quarterly Turkish data comprising mainly the 1980:1-1993:4 period to obtain parameter estimates. The model, divided in the real and financial sector blocks, is based on the following assumptions. The goods prices and the interest rates are less than perfectly flexible. There is imperfect substitution between domestic and foreign goods and assets. The country is a price-taker in international goods markets. There is a crawling peg exchange rate regime, where the rate of devaluation is determined
by the authorities either through a systematic rule (a passive crawl) or at discretion (an active crawl). The final objective in the specification of the goods market is to determine the demand and supply-side pressures on domestic inflation. The analysis of the goods market is based on the simplest open economy setting, where there are two final goods, one composite domestic good and one composite foreign good. Private consumption, private investments, exports and imports are the behavioral functions. The real side also includes the functions which determine the (supply of) capacity output and domestic inflation. The financial part of the model describes the non-bank private sector portfolio balance and the equilibrium in the domestic financial system which is represented by the banking sector. The focus is on the specification of the non-bank private sector asset choice, and of the equilibrium in the domestic loans market. A simple open economy portfolio balance model where asset demands are expressed as a share of total assets is utilized to explain the private sector portfolio choice. It is assumed that domestic banks operate under oligopolistic market conditions and set the lending rate. The stock of bank credits is determined by the demand side, The interest part of the budget deficit and government financing identity are also defined in this block. The financial sector is designed in a way that the implications of alternative rules for the nominal devaluation and different modes of deficit finance can be examined. We now focus on the specification of the inflation equation, a key variable. The other equations of the model in estimated form are given in the appendix. The adjustment in the goods market is based on the disequilibrium notion of an open economy as introduced by Dornbusch (1976). The original Dornbusch specification is modified by explicitly specifying expectations regarding the general price inflation (see van Wijnbergen, 1986). Inclusion of the expected inflation enables us to incorporate directly the effect of the exchange rate expectations on domestic inflation under real exchange rate targeting.
Table 1. Stationarity tests on the relative PPP in Turkey, 1980.1-1993.4 Name of test Unit root White noise Engle-Granger Cointegration
Test statistics
t-values
Critical value at 5%
Augmented Dickey-Fuller a Ljung-Box with Q(8)c Augmented Dickey-Fuller a
-2.32 b 3.76 (0.43)d
-2.92b
-2.018
-3.46
aBased on 4 lags. bAn intercept term is included in the regression. °With 8 degrees of freedom. dFigure in parenthesis gives the probability that the series is whitenoise.
EXCHANGE RATE TARGETING AND INFLATION In its basic form, the inflation rate (/5) then depends on the demand pressure as represented by the ratio between actual and capacity output (~) and on the expected general inflation rate (~e).
We define two relevant production functions, one corresponding to the actual demand-determined output (y) and other to the capacity output (~). Furthermore, we adopt a simple one-factor production function, where output is proportional to the capital stock and the capital-output ratio (p). Recalling that output is demand-determined (equation 6 in the appendix), the production function for (y) then determines the relevant capital stock (K). A simple capital accumulation rule is used to define the installed capacity or actual capital stock (R'). Through simple substitution the demand pressure is finally expressed as the (K) ratio, which provides a measure of capacity utilization. Finally, we define the index for the expected general inflation to substitute (g~) out,
where, the rate of change in general prices is given as an average index of the rate of change in domestic and foreign good§ prices. The rate of change in domestic prices (P) is consequently expressed as a function of the capacit2 utilization rate (~), the expected devaluation (E e) and foreign inflation (P*~), and the lagged dependent variable (/5 I) to account for inertial part of inflation. K k = :&o + 351 ( } ) + d~2/~ e + ,~s3b ,~ +,~54b L ~51 • 0, ~52 > 0, ,~53 > 0, 0 < :954 < l
(la)
where, ~51 = A/(1 - 3~) is obtained by substituting for (~). To the extent that the crawling peg (which is an ingredient of the real exchange rate targeting) functions like a flexible exchange regime it is the exchange rate which is primarily influenced by money creation. Therefore, the monetary financeinflation spiral is weakened, and the exchange rate becomes the main transmission channel (see Kamas, 1995). The complete model, which consists of 21 endogenous variables 14 (11 behavioral equations and l0 identities), is applied to quarterly Turkish data mainly for the 1980:1-1993:4 sample period. Some major observations from estimation on the real
1721
sector equations are as follows (see the appendix for the complete parameter estimates): -relatively high real exchange rate elasticities are found in the import and export demand functions. - - these elasticities are also large in the consumption and investment demand functions; - - a J-curve effect is observed in the export function; 15 and - - domestic inflation is very flexible in Turkey, i.e. it adjusts very quickly or it is not inertial.
(b) Simulation experiment.s" In this section we first examine the consequences of adopting a constant real exchange rate rule based on the relative PPP, where the devaluation rate is fully indexed to the price differential. We ask what would have happened if such a rule had been adopted? Next we deal with the issue of policy credibility. The relative PPP rule with information lag is given by
t2 = (/' - ,a,) ,, where/~ is the rate of crawl, and /5 and/5* are the domestic and foreign inflation rates. We compare the simulation results based on this rule with baseline simulations where the crawl is exogenous] 6 We run the simulation for the 1985:1-93:4 period. The differences in real output, inflation, and the trade deficit-output ratio from the baseline simulation are presented in Figure 3. If the relative PPP rule had been adopted between 1985:1-1993:4 it would, on average, have resulted in: - - a higher domestic output (by 3.19%); - - a significant improvement in the trade deficit (the deficit-output ratio drops from 2.18 to 1.02%);
- - a negligible increase in domestic inflation (by 0.24 percentage points). These results are an indication that the relative PPP rule, compared to the baseline situation, is in general superior: significant improvements in domestic output and the trade balance outweigh a negligible rise in domestic inflation. In this subsection we examine the role of policy credibility or devaluation expectations in real exchange rate targeting. We deal with this issue by explicitly specifying alternative scenarios for policy credibility and incorporating them into the simulation model. Before concentrating on the specification of alternative credibility cases, we first discuss the relevance of the issue in Turkey. As previously mentioned, the policy makers'
1722
WORLD DEVELOPMENT IO.O -
!
7.5 -
/
Output
5.o
/-../
/\
-
N'tll ,, \ 1 ^ \ I \ I \ v
2.5-
/~,
i .a / \/I\ , , I,
,
I
J
k
1--...~
I~
o.o ["r--'~--~. ~ I
|
x I
~
\l
1985
I
%I
-2.5 I
-5.0 /
,~
i |
/ ~
t
/
I
// % I /
",,.,..~
"\
,
\
....
lraQe tlell.
%1
/\
Inflation t
/
j
i~
I
I
/
I
.~.l
k
.
~ i . I
t
J
X"
r
~
~
~ . -
%1 - ' ' ~
I
~
x.. s/
ratio
V
\1/"
-/
i •
i.I
/ \ ,l i - '
/i
I
I
I
I
I
I
I
I
1986
1987
1988
1989
1990
1991
1992
1993
Figure 3. Output, inflation, and trade deficit-output ratio (difference from baseline in percentage). concern has gradually shifted from the external competitiveness to the internal stability, especially to the fiscal and price stability. The real devaluation policy has been slowed down to reduce the pressure on the government budget and inflation. In consequence, the exchange rate devaluation has been lower, resulting sometimes in a real appreciation, This has particularly alleviated the foreign debt service pressure on the government budget. Given the highly liberalized foreign exchange regime and external capital account, however, the relief through lower devaluation on the fiscal balance could not be permanent. Lower devaluation can only be realized by a continuous rise in the domestic interest rates. Under capital mobility, intentionally lower exchange rates can only be achieved at the expense of higher domestic interest rates (which must compensate for the expected devaluation). In the end, the pressure from foreign debt service is temporarily reduced at the expense of domestic debt service. A financial crisis which originates in the foreign exchange markets and spreads to the rest of domestic financial system will also probably accompany. Recently, Turkey survived from a so-called confidence crisis which occurred in early 1994. This is an appropriate place to emphasize the changing pattern of the foreign exchange problem in Turkey. In the late 1970s and early 1980s, the foreign exchange crises originated basically in the current account and undermined the capacity to import (i.e. a real foreign exchange constraint). In contrast, the recent confidence crisis originated mainly in the domestic foreign exchange market, enhanced through the
capital account, and they threatened the stability of domestic financial system. By this we do not mean, however, that the deterioration in the current account had no role in the recent foreign exchange crisis. It did have a role but only gradually due to the accumulated current deficit. Although the exchange rate regime is a highly flexible crawling peg, maxi-devaluations were necessary to get out of the confidence crisis. Figure 4, which plots the devaluation rate along with the interest rate differential (a proxy for the expected devaluation), is very illustrative. Mid-1985 is a dividing line. Beforehand, the interest rate differential stayed below the actual devaluation, while afterwards it exceeded the actual devaluation, except two occasions of maxi-devaluations. We now concentrate on the policy credibility under crawling peg regime. We distinguish two policy regimes: the passive (flexible) and the active (fixed) crawling pegs. In the passive crawl, the devaluation is indexed to some economic variables that are not usually under the (direct) control of authorities. A usual example is the relative purchasing power parity, which we have just applied. In the active crawl, the indexation of the exchange rate depreciation is abandoned, i.e, it is fixed. Here the priority is to fight domestic inflation rather than to increase the external competitiveness. The policy can be incorporated in two ways. The crawl can either be set to zero or it can be fixed to (a basket of) foreign currencies. We prefer to use the former for its simplicity. It implies that the exchange rate is fixed at its initial level. Policy credibility impinges on the expected rate of
EXCHANGE RATE TARGETING AND INFLATION
1723
25
20 Devaluation rate
I
iI
..
e~
I ~
10
g/ \
I
\
5 itl/:r;,rta ,i ; 0 80
81
82
I 83
I 84
I 85
I 86
87
I 88
L 89
L 90
91
I 92
I 93
Figure 4. Exchange rate depreciation and interest rate differential. devaluation or the expected crawl ~e. The policy is said to be credible if it is consistent with the public' s expectations. In this case, the regime is perceived as sustainable, i.e. has not to be reversed soon. The result of non-credibility is, however, a speculative run on the domestic banks and foreign exchange reserves, a crisis in the domestic banking system, and the abandonment of the regime. Two polar cases of credibility relevant for the fixed regime are identified. A fully credible and a noncredible (confidence crisis) case. The f u l l credibility characterizes the situation when the public expectations are consistent with the fixed regime which sets the actual crawl. That is, the actual and expected rate of devaluation are identical,
Where, it) and io are the domestic and foreign deposit interest rates per quarter. We consider only the fully credible case for the passive crawl, where the crawl is governed by the relative PPP and is identical with the expected devaluation. This perfect foresight specification, which was actually adopted above, is consistent with the passively crawling regime. It is argued that the actual rate of devaluation is a good predictor of the expected devaluation in the presence of passive crawl (see del Castillo, 1992).17 The simulation path corresponding to the passive crawling peg regime is denoted by S I M 1 . The simulation paths corresponding to the fully credible and non-credible cases of the fixed regime are respectively denoted by S I M F I X 1 and S I M F I X 2 . To repeat, the three simulated paths displayed in the graphs and the governing rules are,
The c o n f i d e n c e crisis emerges when the public expectations are inconsistent with the fixed regime. That is, the actual and expected rate of devaluation are different,
SIM1
/P
= = (/" -- /-'*)-1 (fully credible flexible regime, the relative PPP)
SIMFIXI
Ee = E ~ 0 (fully credible fixed regime)
SIMFIX2
F e = ( i o - i ~ ) ; E = O(non-
credible fixed regime) In this c a s e the divergent rate of the expected devaluation E e needs to be specified. We have two alternatives. It can be set either to the inflation differential (through the relative PPP) or to the interest rate differential (through the uncovered interest parity, UIP). We have chosen the latter, giving E~ = ( io - io*)_1
The deviations of domestic output, the trade balance-output ratio, and domestic inflation from their baseline values are represented below. ~s (See Figures 5-7). Fixing the nominal exchange rate under the full credibility and non-credibility scenarios has the following consequences in comparison to the baseline simulation:
1724
WORLD DEVELOPMENT 15
a loss of 4.48% and 8.16% in real output under respectively the fully credible and non-credible cases; - - an increase of 2.83 and 5.79 percentage points in the trade deficit-output ratio under respectively the full credibility and non-credibility; - - a decline of 4.65 percentage points in domestic inflation under the full credibility and a 1.59 percentage points increase under the non-credibility. 19
--
10
-
j
5 0
............... ~
-10 -15
4. POLICY CONCLUSIONS
SIM 1
° .x
. . . . . . . SIMF|XI -- -- -- S I M F I X 2 --
"" ~.. . . . . . "" x
I
J
I
I
I
I
92.2
92.3
92.4
93.1
93.2
93.3
F i g u r e 5.
10.0
"...-.7
-5
-20 92.1
The main policy conclusions, based on the simulation experiments, can be summarized as follows. A devaluation (indexation) rule based on the relative PPP, a constant real exchange rate targeting, seems to be superior to the policy actually implemented because it would have led to - - higher growth, -- lower trade deficit-output ratio, -- moderate pressure on domestic inflation. This also means that a real exchange rate appreciation has a contractionary effect on domestic output in Turkey, which is a characteristic of the demand-determined output case. On average, a 3.19% higher real growth might have been achieved over 1985-93 if a constant real exchange rate policy (via the relative PPP rule) had been adopted. Moreover, a well-defined rule might have an additional beneficial effect by eliminating uncertainty. In this respect, the 1994 confidence crisis, which originated in the domestic foreign exchange market and undermined the stability of the domestic financial system, is noteworthy. This crisis can be seen as an accumulated effect of a lower devaluation policy which lacked a clear rule. The crisis might have been avoided if the relative PPP had been followed: the simulation experiment based on this rule indicated a 30% overvaluation by the end of
Real output (in percentage deviation from baseline).
1993, which is roughly the same amount as the actual devaluation undertaken in January and February 1994 to overcome the crisis. Furthermore, it might have contributed to the stability of the goods market by providing correct information on the likely evolution of relative prices. The real exchange rate depreciation tends to improve the trade balance but in an unstable way due to the J-curve effect in the export function (which is a quarter with an elasticity of 28%). The implication of the J-curve effect is that the improvement in the trade balance, a key target in the exchange rate management, will not be stable. In short, the trade balance improvement through real exchange rate targeting is possible but it seems destabilizing in nature. If the priority is to reduce domestic inflation, a fixed (or predetermined) exchange rate policy is the option. Reduction in inflation is, of course, bought especially by lower output and a higher trade deficit. The reduction in inflation can only be achieved, however, if the public perceives the fixed regime as credible or sustainable. Credibility requires that the public expects no (or an equal devaluation when it is predetermined) devaluation. If the fixed exchange rate policy lacks credibility the results are detrimental: drastic deterioration in real output and the
-SIM 1
7.5 --
• .....
5.0 --
- -- - S I M F I X 2
2.5 - -
SIMFIX1
f tl ~.~
......
. . ~ :~ :...":-: : : :':
0.0 -2.5
~
-5.0
-7.5 92.2 F i g u r e 6.
J
]
I
]
t
I
92.3
92.4
93.1
93.2
93.3
Trade deficit-output ratio (difference from baseline in percentage).
EXCHANGE RATE TARGETING AND INFLATION
2.55"0~_
/
/x
1725
\
/
X
0.0 2.5 f -5.0 -7.5 92.1
.-. .---. . . SIMFIXI S1MFIX2
"'"'" . o" ...°.."
*o
•
I 92.2
,.o°"
-- ..o ...
"...-" I 92.3
L 92.4
"• .. I 93.1
t 93.2
I 93.3
Figure 7. Domestic inflation (difference from baseline in percentage). trade balance is n o w c o m b i n e d with a higher inflation. Establishing f o r w a r d (futures) e x c h a n g e rate markets in the domestic e c o n o m y may help to hedge the risk (and to reduce the cost) o f foreign exchange transactions and therefore the speculative part o f the exchange rate depreciation. As a result, the indexation (of actual devaluation) can be lowered without endangering the credibility. Second, the forward markets can serve as a guide for the g o v e r n m e n t in the exchange rate management: forward rates can provide a first hand information about the expected devaluation and thus help to avoid confidence crisis. A final point concerns a r e n e w e d policy debate in
Turkey on restoring confidence in the domestic currency, the Lira. It is proposed that several digits be dropped from the lira in order both to simplify accounting and increase the purchasing p o w e r (and consequently the store o f value) o f the domestic currency. Such a basically accounting operation should be a part o f a more extensive stabilization package whose ultimate aim is to regain price stability (i.e. to stabilize inflation at an reasonable low rate). The package may involve price freezes, including the e x c h a n g e rate, g o o d s prices and 20 interest rates. As verified in the model simulations, however, a prerequisitive for the achievement o f this goal is that the package be credible.
NOTES 1. Although there are other policies to attain a given real exchange rate, the nominal exchange rate is preferred because it is usually more flexible to manage and has a more direct effect on the real exchange rate. But the real exchange rate has not been the only real target used by the authorities. A real interest rate target (inflation-indexed nominal interest rate) on government securities, called as TEFE+, where TEFE denotes the inflation rate based on WPI, has also been used in Turkey.
able. Consequently, a common expectation among both general public and exporters has emerged: the depreciation will closely follow the domestic inflation rate.
2. This dos not mean that real exchange rate targeting necessarily leads to price indeterminacy.
7. The real exchange rate is computed as: RER=EP*/P, where (P) and (P*) are, as before, the WPIs of Turkey and the United States, and E is the index of official nominal exchange rate (TL per US $). A rise in the index means a real depreciation while a decline means a real appreciation.
3. A most recent review is provided in Calvo et al. (1995). Other relevant studies are Dornbusch (1992), Adams and Gros (1986), Lizondo (1991), Lizondo (1993), Montiel and Ostry (1991)Montiel and Ostry (1992). Similar issues were earlier discussed in Williamson (1981) in the context of Latin America. 4. In the same period, an extensive deregulation of domestic interest rates, goods prices and the foreign exchange regime took place. 5. The environment in which exchange rate expectations are formed is worth noting. The role of the exchange rate depreciation in export promotion has been unquestion-
6. The PPP exchange rate was computed as the ratio of domestic WPI to that of United States. The actual nominal exchange rate is the average of buying and selling rates at the inter-bank spot exchange market.
8. The trend behavior of the real exchange rate is consistent with the progress of the Turkish economy and alone can represent the cycles or the phases in the economy. The first period corresponds to the most successful phase, in which there was an export boom, decline in inflation and budget deficit, etc. In the second period there was a stability in exports, and inflation and budget deficit revived a bit. The last period corresponds to a deterioration in exports, inflation and budget deficits due to both rising political tension (frequent elections) and loose policy measures (especially lower nominal exchange rate depreciations).
1726
WORLD DEVELOPMENT
9. See, e.g., Dornbusch and Giovannini (1990) for alternative ways of testing the PPP relationships.
15. We did not attempt to provide detailed theoretical explanation for this result. See Bahmani-Oskooee and Malixi (1992) and Domac (1993) for this purpose.
10. In a fixed regime, the exchange rate variable is assumed to be constant and can be left out (see Edwards, 1993).
16. In addition, other policy variables (e.g., ratios alternative deficit finance) are also set to their actual level in the baseline simulation.
11. As noted before, the US price represents the world price, and the wholesale prices are used in every case.
17. We have also experimented with an alternative, i.e. less than fully credible version of the relative PPP rule by setting the expected devaluation to the interest rate differential. The results, whose divergence from the baseline simulation is negligible compared to those of the fixed regime, are not presented here because four curves on the same graph distort the visual inspection.
12. Logarithmic forms of the price level variables were used. 13. In the original model we are concerned with the tradeoff between internal stability and external competitiveness. Internal stability as defined there also includes the fiscal (mainly interest part of the budget) and financial stability (currency substitution or dollarization), as well as the price stability.
19. Note that this increase occurs when the exchange rate (which explains 36% of inflation) is fixed, i.e., when there is no feedback from the devaluation.
14. Note that this is the core model where the rule for exchange rate policy is not yet included.
20. These are of course short-term measures that pave the way for a viable solution, which requires especially the correction of fiscal imbalance.
18.
The simulation period is 1992.1-1993.3.
REFERENCES Aghevli, B., Bijan, M., Khan, S. and Montiel, P. J. (1991) Exchange rate policy in developing countries: some analytical issues, Occasional Papers, no. 78. International Monetary Fund, Washingon DC. Adams, C. and Gros, D. (1986) The consequences of real exchange rate rules for inflation: some illustrative examples. IMF Staff Papers 33(2), 439-476. Asikoglu, Y. and Uctum, M. (1992) A critical evaluation of exchange rate policy in Turkey. World Development
20(10). Bahmani-Oskooee, M. and Malixi, M. (1992) More evidence on the J-curve from LDCs. Journal of Policy Modelling (October, 1992). Calvo, A. G., Reinhart, C. M. and V6gh, C. A. (1995) Targeting the real exchange rate: theory and evidence. Journal of Development Economics 47(1), 97-133. del Castillo, G. (1992) Policy fundamentals, interest rate differential, and expected devaluation in the presence of an active crawling peg system. Journal of International Money and Finance 11(2), 292-303. Domac, I. (1993) The J-curve phenomenon and its existence in Turkey, Yapi Kredi Economic Review Vol. 6, January 1993. Yapi Kredi Bank, Istanbul. Dornbusch, R. (1976) Expectations and exchange rate dynamics. Journal of Political Economy 84(6), 11611176. Dornbusch, R. (1992) PPP exchange rate rules and macroeconomic stability. Journal of Political Economy 90(i), 158-165. Dornbusch, R. and Giovannini, A. (1990) Monetary policy in the open economy. In Handbook of Monetary
Economics, ed. B. M. Friedman and F. H. Hahn, Vol. II. North Holland, Amsterdam. Edwards, S. (1993) Exchange rates, inflation and disinflation: Latin American experiences, Working Papers, No. 4320. National Bureau of Economic Research, Cmabridge, MA. Erol, T. (1996) Exchange rate policy in Turkey: External competitiveness and internal stability, 1980-1993, Research Series No. 113. Tinbergen Institute, Rotterdam, The Netherlands. Kamas, L. (1995) Monetary policy and inflation under the crawling peg: some evidence from VARSs for Colombia. Journal of Development Economics 46(1), 145-161. Lizondo, J. S. (1991) Real exchange rate target, nominal exchange rate policies, and inflation. Revista de Analisis Economico 6(1), 5-21. Lizondo, J. S. (1993) Real exchange rate targeting under imperfect asset substitutability, Working Papers, No. 93/ 38. International Monetary Fund, Washington DC. Montiel, P. J. and Ostry, J. D. (1991) Macroeconomic implications of exchange rate targeting in developing countries. IMF Staff Papers 38(4), 872-900. Montiel, P. J. and Ostry, J. D. (1992) Real exchange rate targeting under capital control: can money provide a nominal anchor. IMF Staff Papers 39(1), 59-78. van Wijnbergen, S. (1986) Exchange rate management and stabilization policies in developing countries. Journal of Development Economics 23(2), 227-247. Williamson, J. (1981) Exchange Rate Rules: Theory, Performance and Prospects of the Crawling Peg, ed. J. Williamson. Macmillan, London.
EXCHANGE RATE TARGETING AND INFLATION
1727
APPENDIX A: THE EMPIRICAL MODEL W I T H P A R A M E T E R ESTIMATES (a) Domestic price inflation p
=
(g) Installed fixed capital stock
0.08 + 0.36E + 0.11/b~
-
+ 0.21CAPUTLP + O.03SEAS1
R = R-I (1 - 6) + invp + invg (Al) (h) Utilized fixed capital stock
- O.04SEAS3 + 0.002P_I K = py (b)
(A7)
(A8)
Real private consumption demand
log(consp) =
(i) Nominal budget deficit
1.52 - 0.13(isR) - O.151og(EoP*/P) + 0.791og(y - tax)
(a2)
DEFG = (CONSG + INVG - TAX)
(A9) + O.04SEAS3 + O.031og(consp)_4
(c) Real private investment demand
+ INTD + INTF
(j) Government interest payments on domestic debt
log(invp) = - 4 . 4 5 + 6.281og(1 + CAPUTLP)
INTD = 0.333(LOANG + LOANG_~
(AI0)
+ 0.351og(y) - 0.40log(1 + i~)
+ LOANG_2)iL
(A3) + 0.261og (EoP~/P) - O.05SEASI
(k) Government interest payments on foreign debt
+ O.02SEAS2 + 0.461og(invp)_4
INTF = 0.333(FLOANG + FLOANG_~
(d) Export demand at constant domestic prices + FLOANG_2)0.333 log(expo) = - 1.93 + .281og(EoP*JP)_l
(A 11 )
(i~ + i~_ l + i~_2)
+ O. 151og(oecdimp) + O.05SEAS3
(1) Private sector asset demands (A4)
-
0.26SEAS4 + 1.991og
CUR W
(1 + CAPUTLP)
-
0.0163 - 0.0543isR - 0.1319i~ - 0.0144i~: - 0.2304P
+ 0.361og(expo)_ 1
(A12) + 0 . 3 0 4 6 ( ~ ) - O.O004TIME3
(e) Import demand at constant domestic prices
+ 0.1776(-~)_, log(impo) = 2.79 - 0.601og(EoP*m/P) + 0.29log(absorb) - O. 18SEAS1 (A5)
SDEP
-
0.1083 + 0.3252i~ - 0.3293i~
W
+ O.12SEAS4 + 0.511og(impo)_ l -
0.0869iRF -- 0.2131 (---W) (AI3)
(f) Real domestic output
- O.O187SEAS1 - 0.0139SEAS4
y = consp + consg + invp + invg
(A6) + expo - impo
0 4412
+
.
SDEP (--if--)_,
1728
WORLD DEVELOPMENT
TDEP
(p) Residual financial asset in the private sector
= 0.1723 - 0.3381i~ + 0.2774i~
portfolio
W -
O.O013TIME3 - 0.0186SEAS3
(A14)
TDEP
+ AErDEP* + i~(CUR/P)
• -0.0233SEAS4 ÷ 0.6392( _--zz7-_.) ~ ~
FDEP
W
~
(a19)
= 0.0093 - 0.1427isR + 0.1543i~
Wre~ = W - CUR - SDEP - TDEP - FDEP (A20)
W
- 0 . 0 6 1 3 ( 1 ) + O010TIME2 -
AVp = (y -- consp -- invp)P - TAX + iLLOANG
(AI5) (q) Government financing identity (which determines the supply o f central bank credit to the government)
0.0093SEAS2 + 0 . 9 5 5 0 ( ~ - ~ ) _ ~
A D C = DEFG - A L O A N G + A F L O A N G
(A21)
(m) Real interest rate on domestic loans (credits) i~ --
(r) Classification o f variables
- 0.09 + 0.64i~i s + 0.27i~ + 0.54LOANSP_ ~
(A 16)
+ 0.30LOANSG_I ~+ 0.30i~-1
(n) Private sector demand for domestic loans (credits) LOANP -
INVP
-
(A17) 0 2
LOANP
. 6(~)_,
-
LOANP
(s) Explanations about the notations for symbols and operators
(o) Private sector balance sheet and budget constraints w
Exogenous variables: CONSG, INVG, WAGE; LOANG, FLOANG, E, E, is, iT, iD*, iL*, Px*, Pro*, p.n. Exogenous parameters: 5: amortization rate of fixed capital stock (=0.025), p: capital-output ratio (=2).
- 0.02 - 0.40i~ + 0.27i~* + 0.10(/--~) +
Vp =
21 endoge~nous variables: consp, invp, expo, impo, y, K, [(~, DEFG; P, iR; CUR/W, SDEP/~, TDEP/W, FDEP/W, Vp, W, Wres, LOANP/1NVP, DC; IND, INTF.
(A18)
- - Upper case symbols mostly refer to nominal variables (exceptions are the fixed capital stock and wage rate) while lower case symbols refer to real variables, ^ (above a variable) refers to rate of change,* (above a variable) refers to a foreign variableA (before a variable) refers to change.
EXCHANGE RATE TARGETING AND INFLATION
(t) Alphabetic list of all variables used
CAPUTLP consp CONSG CUR
capacity utilization rate in the private sector real private consumption public sector consumption at current prices household demand for domestic currency (nominal) DC central bank credit to the government (nominal) DEFG budget deficit (nominal) SDEP domestic short-term (demand) deposits (nominal) nominal foreign exchange rate and its rate of change FDEP foreign exchange deposits in domestic currency FLOANG foreign borrowing by the government in domestic currency is,i~ nominal and real interest rate on domestic short-term deposits iT,i~ nominal and real interest rate on domestic time deposits nominal foreign interest rates on foreign iD*,iL* deposits and loans it,, iL R nominal and real interest rate on domestic bank loans impo real total imports INTD government interest payments on domestic debt (nominal) INTF government interest payments on foreign debt (nominal)
invp INVG g
K LOANP LOANG oecflimp p, p Px*, Pm* Pn*
RES SEAS~ TAX TDEP WAGE Vp W
Wres Y Y y,
1729
real private investment public sector investment at current prices stock of actually utilized fixed capital (real) installed fixed capital stock (real) private sector demand for domestic credits (nominal) public sector demand for domestic credits (nominal) volume of OECD real import (index) domestic price index and inflation rate foreign currency prices of export and imported consumer goods foreign currency prices imported capital goods total domestic reserves of the banks at the central bank seasonal dummies government total revenues from taxes and other means (nominal) private sector time deposits (nominal) real wage rate in the private sector, nominal (TL per day) index deflated by CPI non-bank private sector net worth total private financial assets (nominal) residual financial asset in the private sector portfolio real domestic output (demand-determined) capacity output real foreign income
A P P E N D I X B: D A T A S O U R C E S (a) Bank deposits and currency (SDEP, TDEP,
(e) Interest rate on foreign borrowing (i'L)
FDEP, CUR) Source: IFS (International Financial Statistics) for 1980.01-1985.12; CBTUR (Central Bank of Turkey, 1993) for 1986.01-1991.12. CBTUR (1993) is a special issue of monthly money and banking statistics for 1986.011991.12; CBTUR Quarterly Bulletins for 1992.01-1993.12.
Source: World Debt Tables, various issues, The World Bank.
(f) Foreign exchange rate (TL per $: E=TL/$) Source: CBTUR, Quarterly Bulletins.
(b) Domestic borrowings (DC, LOANP, LOANG) Source: same as financial assets above.
(g) Interest payments by the public sector (INTD and INTF) Source: Under-Secretary of Treasury.
(c) Public sector foreign borrowing (FLOANG) (h) Turkish and US domestic price indexes (Pd, P,~) Source: Under-Secretary of Treasury and Foreign Trade. Source: OECD (monthly) Main Indicators on Economics
Mainstream Data Disks. (d) Interest rate on bank deposits and loans (is, it, t D,IL) Source: CBTUR Monthly and Quarterly Bulletins.
(i) Foreign price indices (P~, P~, Pn*) Source: CBTUR, Quarterly Bulletins.
1730
WORLD DEVELOPMENT
(j) Components of GDP (CONSPC, CONSGC, INVPC, INVGC, EXPOTL, IMPOTL)
92, and the 1993 values were calculated from an accumulation equation assuming 2.5% depreciation per annum.
Source: Ozmucur [A quarterly econometric model of Turkey, 1987, TUSIAD] for 1980.1-1986.4, and various News Bulletins of the State Institute of Statistics (ISS) for 1987.1-1993.4. (1) Capacity utilization rate (CAPUTLP) (k) Stock of fixed capital (K) Source: State Planning Organization (SPO) for 1979-
Source: Statistics Yearbooks of the State Institute of Statistics (ISS).