The Long-Run Validity of the Monetary Exchange Rate Model for a High Inflation Country and Misalignment : The Case of Turkey

Abstract

This paper applies the Johansen cointegration technique to examine the validity of the monetary model of exchange rate determination as an explanation of the Turkish lira-U.S. dollar relationship over 1987:1-2000:12. A single cointegrating vector is identified, lending support to the interpretation of the model as describing a long-run equilibrium relationship. We also test for weak exogeneity of the nominal exchange rates and monetary fundamentals from the estimated vector error correction models. This gives us insight into the adjustment process through which the long-run equilibrium relationship between exchange rates and monetary fundamentals is maintained. In addition, we calculate misalignment from estimating the long-run relationship to evaluate whether the lira was overvalued before the eve of the 2001 financial crisis in Turkey. Calculated misalignment figures show substantial overvaluation before the crisis.