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Is Currency Depreciation or Appreciation Expansionary in Turkey?

Updated: Apr 4, 2018

Prof. Yu Hsing

Joseph H. Miller Endowed Professor in Business, Department of Management & Business Administration, College of Business, Southeastern Louisiana University, Hammond, LA 70402

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Based on an extended IS-MP-AS model (Romer, 2000), this paper finds that real appreciation raised real GDP in Turkey during 2002.Q2-2011.Q2 whereas real depreciation helped increase real GDP during 2011.Q3-2017.Q1. In addition, a lower government debt-to-GDP ratio, a lower lagged world real interest rate, a lower real oil price or a lower expected inflation rate helped raise real GDP. These results suggest that the relationship between aggregate output and exchange rates may be subject to structural changes and that a prudent fiscal policy would be more appropriate.


Turkey’s economy exhibits both progress and concerns. According to the International Monetary Fund (2017), its economic growth rate of 3.184% in 2016 was higher than many other industrialized countries. Its government net borrowing as a percent of GDP declined from a recent high of -5.881% in 2009 to -2.316% in 2016. Its general government gross debt as a percent of GDP dropped from a recent high of 76.401% in 2001 to 28.131% in 2016, which was well below the EU threshold of 60%. The inflation rate has been on the decline from a recent high of 104.54% in 1994 to 7.775% in 2016, which was slightly higher than the 5% inflation target (Central Bank of the Republic of Turkey, 2017). The Turkish lira had depreciated as much as 132.05% versus the U.S. dollar during 2008-2016, suggesting that its potential impacts on aggregate output may need to be investigated. Several studies including Turkey in the sample have examined the effect of currency depreciation or appreciation on aggregate output.

Gylfason and Risager (1984) report that a 10% devaluation would result in a 3.4% increase in real output in Turkey. Nunnenkamp and Schweickert (1990) devaluation is expansionary in the 22 countries including Turkey in the low middle-income group. Morley (1992) finds that devaluation is contractionary mainly because of a substantial decrease in investment. Domac (1997) indicates that there is lack of evidence of contractionary devaluation. Kalyoncu, Artan, Tezekici, and Ozturk (2008) show that devaluation is contractionary in the short run and that there is cointegration in the long run. Sencicek and Upadhyaya (2010) reveal that devaluation is contractionary in the short run, expansionary in the medium run and neutral in the long run. Tavakoli and Kheradmand (2013) point out that the impact of a currency crash on economic growth in Turkey is statistically insignificant. Gülay and Pazarlioğlu (2016) find that real appreciation has negative effects on economic growth. Yildirim and Ivrendi (2016) discover that significant currency depreciation causes a deep recession, high inflation, and an improved trade balance. Some of these studies have different findings mainly because different models, methodologies and sample periods are used.

This paper focuses on the impacts of exchange rate movements on aggregate output in Turkey based on an extended IS-MP-AS model (Romer, 2000). Other relevant economic variables will also be considered. Several studies of the effect of real depreciation on aggregate output select the money supply as a proxy for monetary policy (Agenor, 1991; Morley, 1992; Moreno, 1999; Bahmani-Oskooee, 1998; Bahmani-Oskooee, Chomsisengphet and Kandil, 2002; Kim and Ying, 2007; Ratha, 2010; An, Kim and Ren, 2014; Kim, An and Kim, 2015). Romer (2000) proposes that a monetary policy function incorporating inflation targeting (Taylor, 1993, 1999; Ege Yazgan and Yilmazkuday, 2007; Yilmazkuday, 2008; Akyurek, Kutan and Yilmaskuday, 2011) would be more appropriate as many countries including Turkey has adopted inflation targeting in setting the policy rate. The innovation of this paper is the consideration of several new variables such as the real effective exchange rate, the world real interest rate and the real oil price in the extended IS-MP-AS model in order to explore the impacts of international trade and finance, an open economy and supply shocks on aggregate output.

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