Real exchange rate targeting and inflation in Turkey: An empirical analysis with policy credibility

Abstract

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.