Inflation Targeting in Developing Countries and Its Applicability to the Turkish Economy

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Virginia Tech

Inflation targeting is a monetary policy regime, characterized by public announcement of official target ranges or quantitative targets for price level increases and by explicit acknowledgement that low inflation is the most crucial long-run objective of the monetary authorities. There are three prerequisites for inflation targeting: 1)central bank independence,2)having a sole target,3)existence of stable and predictable relationship between monetary policy instruments and inflation.In many developing countries, the use of seigniorage revenues as an important source of financing public debts, the lack of commitment to low inflation as a primary goal by monetary authorities, considerable exchange rate flexibility, lack of substantial operational independence of the central bank or of powerful models to make domestic inflation forecasts hinder the satisfaction of these requirements. This study investigates the applicability of inflation targeting to the Turkish economy. Central bank independence in Turkey has been mainly hindered by "fiscal dominance" through monetization of high budget deficits. In addition, although serious steps have been taken recently under a new law to have an independent central bank, such as formal commitment to the achievement of price stability as the primary objective and the prohibition of credit extension to the government, the central bank does not satisfy independence criteria due to the problems associated with the appointment of the government and the share of the Treasury within the bank. Having a sole inflation target was hindered by the existence of fixed exchange rate system throughout the years. However, in February 2001, Turkey switched to a floating exchange rate regime, which is important for a successful inflation-targeting regime. Having a sole target within the system has also been supported by the new central bank law, which gives priority to price stability and supports any other objective as long as it is consistent with price stability. In this thesis, an empirical investigation has been made in order to assess the statistical readiness of Turkey to satisfy the requirements of inflation-targeting by making use of vector autoregressive (VAR) models. The results suggest that inflation is an inertial phenomenon in Turkey and money, interest rates and nominal exchange rates innovations are not economically and statistically important determinants of prices. Most of the variances in prices are explained by prices themselves. According to the VAR evidence, the direct linkages between monetary policy instruments and inflation do not seem to be strong, stable, and predictable. As a result, while the second requirement of the inflation-targeting regime seems to have been satisfied, there are still problems associated with the central bank independence and the existence of stable and predictable relationship between monetary policy instruments and inflation in Turkey.

Central Bank independence, Vector autoregressive, Inflation-targeting