Wednesday, January 26, 2011

Internalizing the flexible exchange rate regime

Ozan Gaziturk, economist at Sekerbank (and the Fernandes of my gang) makes the following keen observations:

The relationship between the exchange rate basket (50% EURTRY, 50% USDTRY) and inflation broke down in April, 2008:
Similarly, the relationship between the exchange rate (USDTRY) and consumer confidence has been broken since the end of that same year:
These are well-known by Turkey economists, but I really liked how Ozan put this all together: He notes that dedollarization is only part of the answer to "why". The main reason is that Turks have internalized the flexible exchange rate regime: Turks do not use the exchange rate for pricing forming their confidence of the economy. But they still trade USD and EUR!

Ozan notes that this internalization was unavoidable, as the exchange rate creeping up did not result in a crisis, but also underlines the oil price shock of April 2008 and the tomato prices later, i.e. supply shocks, as the breaking points in the relationship between inflation and the exchange rate. 

While I would agree with him, I would also highlight the role of the output gap, which decreased the exchange rate pass-through considerably in the crisis and its aftermath.

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