Excerpt

## Contents

Abstract..

List of tables and figures

1. Introduction

2. Derivation of the baseline model

2.1. Households

2.2. Inflation, the real exchange rate and terms of trade

2.3. International Risk Sharing Condition.

2.4. Firms

2.5 Price setting behavior and incomplete path through.

2.6. Equilibrium.

3. The estimation methodology

3.1 Specification of the data and prior distribution

4. Results.

4.1 Parameter estimation and posterior distribution.

4.2. Variance decomposition and Impulse response..

Conclusion

Reference.

Appendix A.

Appendix B.

## Abstract

Using of developments of the last decade in Bayesian estimation, I estimate a small open economy Dynamic Stochastic General Equilibrium (DSGE) model for Turkey. The thesis explicitly accounts for a monetary regime change from an exchange rate targeting to an explicit inflation targeting with a flexible exchange rate. In both regimes, I investigate the behavior of the monetary authority and the main driving forces of business cycles of key macro economy variables of the Turkish economy. My results can be summarized as follows. Monetary policy focused on the stabilizing of the nominal exchange rate in the exchange rate targeting regime. But, it is mainly concerned with the price stability in the inflation targeting regime. Monetary policy shocks were the main sources of the fluctuations under both regimes. However, the foreign output shock in the first regime and the real exchange rate shock in the second regime appeared as the additional sources of the fluctuations in the business cycles. The Central Bank of Turkey managed to neutralize inflationary shocks and achieved stability in output and consumption after the regime change.

Keywords: Turkey, Bayesian estimation, DSGE models, regime change

List of tables and figures

Table1: Business Cycle Facts for Turkey and ROW

Table2: Business Cycle Facts for Turkey and ROW

Table 3: Structural Parameters, Prior and Posterior Distributions-Exchange rate targeting

Table 4: Shocks, Prior and Posterior Distributions.

Table 5: Structural Parameters, Prior and Posterior Distributions-Inflation targeting

Table 6: Shocks, Prior and Posterior Distributions-Inflation targeting

Table7: Variance Decomposition (in percent)-Exchange rate targeting.

Table8: Variance Decomposition (in percent)-inflation targeting

Figure1: Observed Variables

Figure2: Priors and Posteriors of the Exchange Rate Targeting Regime

Figure3: Priors and Posteriors of the Inflation targeting Regime

Figure4: Impulse Responses to Productivity Shock

Figure5: Impulse Responses to Terms of Trade Shock

Figure6: Impulse Responses to Real Exchange Rate Shock

Figure7: Impulse Responses to Home Inflation Shock

Figure8: Impulse Responses to Imported Inflation Shock

Figure9: Impulse Responses to Nominal Interest Rate Shock.

Figure10: Impulse Responses to Foreign Real Interest Rate Shock

Figure11: Impulse Responses to Foreign Output Shock

## 1. Introduction

Until 21 February 2001, the Turkish economy was "ruled" by a fixed exchange rate regime towards the USD. In this period Turkey had a very inflated economy. The main reasons of inflation and consequently economic crises were income-expenditure disbalances in the public sector. Lack of structural and financial reforms made the economy vulnerable to foreign shocks and resulted in several serious inflationary crises in 1988-1989, 1991, 1994 and 1998-1999. In 2000, IMF supported stabilization and disinflation program aimed at tying down inflation which reached a level of 80% and at establishing financial stability. An exchange rate based disinflation and monetary control mechanism set certain tasks for the Central Bank (CB), such as not violating net domestic asset position and avoiding sterilization. But, insufficient funding from ongoing privatization programs and inefficient structural reforms forced the government to continue borrowing at higher interest rates. This led to a loss of monetary policy credibility in both domestic and foreign markets which resulted in further loss of confidence in the ruling authority and an increase of the devaluation expectations. Thus, defending predetermined exchange rate parity was beyond the CB's scope and in February 2001 the Central Bank abandoned fixed parity and let the exchange rate float.

After the currency collapse, the monetary authority switched to a different monetary policy regime, which is a very typical for an emerging market economy which abandons fixed parity. As stated by Taylor (2000), in this case the best policy to stick to for an emerging economy is a flexible exchange rate, an inflation target and a monetary policy rule. As a result, Turkey opted to an inflation targeting regime with a floating exchange rate. The CB continued using short-term interest rates as the main policy tool to reach its policy target in the second regime.

After one decade from starting the inflation targeting, it is time to analyze the relationships between the two monetary policy regimes and macroeconomic stability and evaluating the driving forces of the business cycles of the Turkish economy under both regimes.

Similar researches were done by many authors, especially on advanced economies. Curdia and Finocchiaro (2005) studied a monetary policy regime change in Sweden by employing Bayesian framework. They used modified and conventional Taylor rules as the monetary policy rules for the first and the second regimes respectively. I follow their method in defining monetary policy rules for the both regimes of the Turkish economy in this study which will be discussed later. Seminal paper of Smets and Wouters (2002) made Bayesian estimation one of main tools of quantitative macro analysis in the last decade. My thesis intensively uses their methods in an estimation stage. By using the latest developments in the Bayesian estimation Lubik and Schorfheide (2005) successfully analyzed economies of the U.S. and the Euro Area. They developed two-country model which was modified to a small open economy in this study. I am closely following derivation methods of Haider and Khan (2008) and Liu (2006) in converting Lubik and Schorfheide's (2005) two-country model to a small open economy model.

In this work, I estimate a small open economy Dynamic Stochastic General Equilibrium (DSGE) model on Turkish data with two goals. Namely, my first goal is to estimate monetary policy rules of the exchange rate targeting and the inflation targeting regimes and to clarify whether the Turkish data shows the monetary regime change which was announced by the CB. Furthermore, I aim at disclosing that which shocks triggered changes in the business cycles of the Turkish economy under both regimes, which is a good benchmark for similar analysis for emerging economies. That is why, my work makes two important contributions to the existing literature. First, it estimates a small open economy DSGE model with explicit regime switching by Bayesian methods for the emerging market. The second contribution is that this study quantitatively assesses the behavior of Turkish economy under two different monetary regimes and can serve as a valuable benchmark for future analysis in a similar framework for both Turkey and other emerging economies. To the best of my knowledge, it is a pioneer study for Turkey.

To achieve my goal, I estimate a stochastic business cycle model with deviations from the low of one price (LOP) and Calvo type price setting. The study is enriched by including external habit formation in the utility function in order to capture inertia in consumption which was well documented by King and Rebelo (2000). These rigidities will help to simulate reality and get more trustful results.

Curbing inflation has been the overall target of monetary policy in Turkey since February 2001, but until regime switching price stability used to be one of main goals of CB, as Turkey possessed one of the most inflated economies of Middle East. At the end of 80s and at the beginning of 90s inflation rates fluctuated between 40% and 110% annually (Rivlin,2003). After regime switching, "furious" response of CB to inflation made it possible to chain inflation down to one digit values. Following Curdia and Finocchiaro (2005) I define monetary policy rule for the first and second regime, as modified Taylor rule and "conventional" Taylor rule respectively. As previously stated, remarkable inflation history of Turkish economy validates using modified Taylor rule for the first regime. Modified Taylor rule can be described as an interest rate rule, whereat CB reacts to a change in the nominal exchange rate as well.

Eight structural shocks help the study to analyze economy's stability conditions: shocks to productivity, monetary policy, terms of trade, exchange rate, foreign interest rate, foreign output, domestic inflation and imported inflation. Meanwhile, the paper employs eight time series: foreign real interest rate, foreign output, domestic output, domestic nominal interest rate, domestic inflation, imported inflation, real exchange rate and terms of trade.

In estimation part, I closely follow Smets and Wouters (2002), *id est* employing Bayesian techniques and other numerical methods, like Markov Chain Monte Carlo (MCMC), for finding posterior modes, driving forces of business cycles, variance decomposition and impulse response functions.

The estimated monetary policy rule reveals out the strong focus of the CB on exchange rate stabilization in the exchange rate targeting regime. In its term, it limited the monetary independence of the CB by reducing its ability to respond to domestic shocks and made the economy vulnerable to foreign shocks as well. It is clearly visible from the variance decomposition analysis, where the foreign output and the foreign monetary policy shocks are the main sources of the economic fluctuations with the monetary policy shock under the first regime. After the regime change, the CB set price stability as the main target and the real exchange rate appeared as one of the main sources of the economic volatility in the Turkish economy. From impulse response analysis one can easily detect that the responses of variables to the foreign shocks increased in the inflation targeting regime. So, under the inflation targeting regime the real exchange rate transmitted the foreign shocks into the economy more than it did under the exchange rate targeting regime.

Analyzing stylized facts (tables 1 and 2) discloses that after the regime switching the Turkish economy became less volatile in terms of a nominal interest rate, terms of trade and a domestic inflation, as the standard deviations of the mentioned indicators went down after regime change. ( from 27.08 to 5.26,from 4.46 to 2.28, from 43.82 to 7.51 respectively). Notable change in the volatility of the nominal interest rate and domestic inflation proves that the CB implemented very rigid interest rate smoothing and achieved its goal of reducing inflation. But it should be noted that the standard deviation of the real exchange rate approximately stayed unchanged and in the second regime it served as one of the main sources of the cyclical behaviors.

## 2. Derivation of the baseline model

In this section, I derive a small-scale open economy DSGE model for Turkey. I am closely following Haider and Khan (2008), Liu (2006), Gali and Monacelly (2005) and Lubik Schorfheide (2005) in derivation of the key blocks of the model. In order to make the paper self contained, I include the derivation of key equations, which were proposed by Gali and Monacelli (2005) in Appendix A. The model's structure was enriched by including external habit formation, Calvo type price setting and furthermore I assume symmetric preferences and symmetric technology and complete international asset markets. Nevertheless, my model is in high harmony with the above stated models, I employ two different monetary policy rules, for capturing the answer to main questions of my thesis, which were inspired by Curdia and Finocchiaro (2005).

### 2.1 Households

The model describes the economy which is inhabited by a representative household who maximizes her utility through the following equations:

Abbildung in dieser Leseprobe nicht enthalten

(1)

where is intertemporal discount factor representing time preferences, > 0 is the inverse elasticity of intertemporal substitution in consumption and >1 is the inverse elasticity of labor supply. *Nt* denotes hours worked. The model allows for external habit formation with is aggregate consumption index for foreign and domestic goods:

Abbildung in dieser Leseprobe nicht enthalten

(2)

whereat 0,1 is the import ratio and captures degree of openness and of substitution between home and foreign produced goods. [Abbildung in dieser Leseprobe nicht enthalten] and > 0 is the elasticity [Abbildung in dieser Leseprobe nicht enthalten]are defined as following:

Abbildung in dieser Leseprobe nicht enthalten

(3)

here > 0 is the elasticity of substitution between varieties. The household's budget constraint is given by the following equation:

Abbildung in dieser Leseprobe nicht enthalten

(4)

for [Abbildung in dieser Leseprobe nicht enthalten] wherein and [Abbildung in dieser Leseprobe nicht enthalten] denote the prices of domestic and foreign good [Abbildung in dieser Leseprobe nicht enthalten] respectively, [Abbildung in dieser Leseprobe nicht enthalten] is stochastic discount rate,[Abbildung in dieser Leseprobe nicht enthalten]is nominal payoff from a portfolio of asset [Abbildung in dieser Leseprobe nicht enthalten] bought at [Abbildung in dieser Leseprobe nicht enthalten] and [Abbildung in dieser Leseprobe nicht enthalten] is the nominal wage.

From optimization problem, we can easily derive the following demand functions for

Abbildung in dieser Leseprobe nicht enthalten

(5)

where is the price index of home and imported goods respectively. From symmetry assumption in preferences and technology we can get the allocation scheme of expenditures:

Abbildung in dieser Leseprobe nicht enthalten

(6)

where is consumer price index [Abbildung in dieser Leseprobe nicht enthalten] (CPI). So, we can state total consumption expenditures for the domestic household by [Abbildung in dieser Leseprobe nicht enthalten]It helps us to express budget constraint as:

Abbildung in dieser Leseprobe nicht enthalten

(7)

Household's maximization problem yields the following first order conditions (FOCs):

Abbildung in dieser Leseprobe nicht enthalten

(8)

Abbildung in dieser Leseprobe nicht enthalten

here [Abbildung in dieser Leseprobe nicht enthalten] is the gross nominal return on a riskfree one-period bond maturing in [Abbildung in dieser Leseprobe nicht enthalten].

Abbildung in dieser Leseprobe nicht enthalten

Equation (8) and (9) express intratemporal optimality condition and Euler equation respectively. Log-linear approximation of equation (6) and FOCs yields:

Abbildung in dieser Leseprobe nicht enthalten

(10)

Abbildung in dieser Leseprobe nicht enthalten

(11)

Abbildung in dieser Leseprobe nicht enthalten

(12)

illustration not visible in this excerpt

(13)

illustration not visible in this excerpt

where lower case letters denote the logs of the respective variables,[illustration not visible in this excerpt] is CPI inflation.

illustration not visible in this excerpt

I assume that households in the rest of the world (ROW) have the same optimization problems with identical preferences and domestic economy has not any influence on the ROW.

That is why, I also assume

illustration not visible in this excerpt

So, equation (12) and (13) is true for the foreign economy as well. (with all variables taking a superscript ()) )

### 2.2 Inflation, the real exchange rate and terms of trade

In this section I derive key open economy relationships between inflation, real exchange rate, terms of trade, international risk sharing and uncovered interest parity. As stated earlier, the model allows deviations from Law of one price (LOP). As Turkey has little bargaining power in international markets, LOP holds for export sector, * id est* for exported goods, prices are determined exogenously in the ROW. I assume due to competition in the world import markets,prices of imported goods are equal to marginal costs at the wholesale level. But, because of rigidities in inefficient distribution network and monopolistic retailers, there is LOP gap in imported prices.

Terms of trade (TOT) is defined as

[illustration not visible in this excerpt] . It can be easily

illustration not visible in this excerpt

spotted that, an increase in TOT means an increase in competitiveness. Log-linearizing the CPI formula around steady state and substituting

illustration not visible in this excerpt

(14)

First difference of equation (14) yields the following relationships:

illustration not visible in this excerpt

(15)

illustration not visible in this excerpt

(16)

From equation (15) and (16) we can state that, the difference between total and domestic inflation is proportional to change in TOT and this proportionality increases with degree of openness. Nominal exchange rate (+), is defined as a foreign currency per unit of a domestic

currency. So, an increase of nominal exchange rate means an appreciation of the domestic currency. Next step is defining real exchange rate and LOP gap respectively:

illustration not visible in this excerpt

(17)

illustration not visible in this excerpt

(18)

illustration not visible in this excerpt

where *P*) is the foreign price index. Note that, if LOP holds, then [illustration not visible in this excerpt] Taking log of (18) and using the formula for TOT yields:

illustration not visible in this excerpt

(19)

illustration not visible in this excerpt

here [illustration not visible in this excerpt] represents the log of nominal exchange rate. From substitution of (19) into (18) and with the help of (14) we can get:

illustration not visible in this excerpt

(20)

illustration not visible in this excerpt

where [illustration not visible in this excerpt]. It can be stated without any doubt that, LOP gap is inversely proportionate to the real exchange rate and degree of international competitiveness.

#### 2.3 International risk sharing and uncovered interest parity

I assume complete international financial markets in my model and I can go further by assuming perfect capital mobility as well. So, then the expected nominal return from riskless bonds, in home currency terms, must be the same as the expected domestic-currency return from foreign bonds. It can be expressed by

illustration not visible in this excerpt

**[...]**

- Quote paper
- Samir Huseynov (Author), 2010, An Estimated DSGE Model For Turkey With A Monetary Regime Change, Munich, GRIN Verlag, https://www.grin.com/document/154551

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