Currency substitution and exchange rate instability: The Turkish case

Abstract

In this paper we present evidence for the extent of currency substitution and its effects on exchange rate instability in Turkey. Following the capital account liberalization in 1987, the private sector has responded to the failed stabilization efforts of successive Governments by requesting higher real interest rates on Government debt and by increasing its holdings of foreign exchange at the expense of domestic currency. Theoretical models of exchange rate determination indicate that exchange rate instability increases with the degree of currency substitution. We use an exponential GARCH (E-GARCH) model for exchange rate depreciation and find evidence in support of this hypothesis. Furthermore we test for the extent of currency substitution in determining short-run dynamics of real money balances utilizing the expected depreciation series obtained from the E-GARCH model.