The Role of Monetary Policy in Turkey During the Global Financial Crisis
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Author“s E-Mail Addresses: harun.alp@tcmb.gov.tr; selekdag@imf.org

Turkey is an interesting case study because it was one of the hardest hit emerging economies by the global financial crisis, with a year-over-year contraction of 15 percent during the first quarter of 2009. At the same time, anticipating the fallout from the crisis, the Central Bank of the Republic of Turkey (CBRT) decreased policy rates by an astounding 1025 basis points over the November 2008 to November 2009 period. In this context, this paper addresses the following broad question: If an inflation targeting framework underpinned by a flexible exchange rate regime was not adopted, how much deeper would the recent recession have been? Counterfactual experiments based on an estimated structural model provide quantitative evidence which suggests that the recession would have been substantially more severe. In other words, the interest rate cuts implemented by the CBRT and exchange rate flexibility both helped substantially soften the impact of the global financial crisis.

Abstract

Turkey is an interesting case study because it was one of the hardest hit emerging economies by the global financial crisis, with a year-over-year contraction of 15 percent during the first quarter of 2009. At the same time, anticipating the fallout from the crisis, the Central Bank of the Republic of Turkey (CBRT) decreased policy rates by an astounding 1025 basis points over the November 2008 to November 2009 period. In this context, this paper addresses the following broad question: If an inflation targeting framework underpinned by a flexible exchange rate regime was not adopted, how much deeper would the recent recession have been? Counterfactual experiments based on an estimated structural model provide quantitative evidence which suggests that the recession would have been substantially more severe. In other words, the interest rate cuts implemented by the CBRT and exchange rate flexibility both helped substantially soften the impact of the global financial crisis.

I. Introduction

Distinct features of the global financial crisis which intensified during September 2008 include a sharp slowdown in global economy activity—including severe recessions across many countries—along with an episode of acute financial distress across international capital markets. Another departure from past global downturns was the coordination of unprecedented countercyclical policy responses to the crisis, which seems to have supported the rebound in economic activity.

Turkey was one of the hardest hit countries by the crisis. Real GDP contracted sharply for four quarters, reaching a year-over-year contraction of 14.7 percent during the first quarter of 2009, resulting in a –4.8 percent annual growth rate for that year. At the same time, anticipating the fallout from the crisis, the Central Bank of the Republic of Turkey (CBRT) decreased policy rates by an astounding 1025 basis points over the November 2008 to November 2009 period.

The recent Turkish experience differs from the past in several dimensions. As discussed further in Section II, Turkey suffered from an intense financial crisis in 2001. While the 2001 crisis was certainly harsh, it was followed by at least two important reforms. First, the pegs and heavily managed exchange rate regimes of the past were replaced by a flexible exchange rate regime. Second, and relatedly, the policy framework of the CBRT gradually transitioned into a full-fledged inflation targeting regime.

Against this backdrop, this paper will focus on the macroeconomic implications of these two monetary policy reforms, particularly during the recent global financial crisis. The principle question of the paper is as follows: What was the role of these changes to the monetary policy framework in mitigating the severity of the recent recession? More specifically, we seek to address the following set of questions: (1) In contrast to the fixed exchange rate regimes of the past, what was the role of exchange rate flexibility in helping insulate the economy from the crisis? (2) Relatedly, consistent with the attainment of the inflation targets, what was the role of the CBRT’s countercyclical interest rate cuts in softening the impact of the crisis?

This paper seeks to provide quantitative answers to these questions. To this end, we develop and estimate a small open economy dynamic stochastic general equilibrium (DSGE) model designed to capture salient features of the Turkish economy. The model contains a number of nominal and real frictions such as sticky prices, sticky wages, variable capital utilization, investment adjustment costs, habit persistence, and incorporates a financial accelerator mechanism à la Bernanke and others (1999) in an open-economy setup to better fit the data. Details regarding the setup of the model, the estimation procedure, its robustness, and its dynamics are briefly covered in Section III through Section V (with many of the details relegated to an extensive appendix).

Using the estimated structural model we can address the main question of the paper reformulated as follows:

  • If an inflation targeting framework underpinned by a flexible exchange rate regime was not adopted, how much deeper would the recent recession have been?

This paper finds that the recession would have been substantially more severe.

We derive this result using model-based counterfactual simulations. These simulations represent the basis for our main policy implications and are discussed in detail in Section VI and Section VII. We contrast the actual realization of real GDP (the baseline scenario), with other counterfactual scenarios that, for example, consider the how the economy would have responded if the CBRT had not implemented any discretionary monetary policy loosening.

To more intuitively convey our quantitative results, we consider the growth rate during the most intense year of the global financial crisis, namely 2009, as our baseline. In this context, our counterfactual simulations indicate that without the discretionary interest rate cuts (expansionary monetary policy shocks) possible under the inflation targeting regime, growth in 2009 would have decreased from the actual realization of –4.8 percent to –5.9 percent, a difference of 1.1 percentage point. This lies within the range found by Christiano and others (2008), which finds growth contributions of monetary policy of 0.75 percent and 1.27 percent for the United States and the Euro area, respectively.

Other insightful counterfactual experiments are possible. For example, if there was absolutely no countercyclical responses to the crisis—in other words the CBRT did not take the output gap into account and at the same time did not implement any discretionary policy loosening (no expansionary monetary policy shocks)—then the 2009 growth outcome would have been –6.2 percent. Moreover, if a fixed exchange rate regime would have been in place instead of the current inflation targeting regime which operates with a flexible exchange rate, the results indicate that growth in 2009 would have been –8.0 percent, a difference from the actual outcome of 3.2 percentage points.

In sum, without the adoption of the flexible exchange rate regime, and active countercyclical monetary policy guided by an inflation targeting framework, the impact of the recent global financial crisis would have been substantially more severe. As emphasized in the final section of the paper, the inflation targeting framework underpinned by a flexible exchange rate seems to have increased the resilience of the Turkish economy to shocks. The inflation targeting framework allowed the CBRT to implement countercyclical and discretionary interest rate cuts, while exchange rate flexibility acted as a shock absorber, both of which increased the resiliency of the economy. The latter result echoes the favorable output stabilization properties of exchange rate flexibility which can be traced back to at least to the seminal contributions of Mundell and Fleming.

Our paper builds on a tradition of small open economy DSGE models popularized by Mendoza (1991). Over time, these real models were augmented with nominal rigidities to motivate and then explore the implications of monetary policy (for example, Gali and Monacelli, 2002, among others). To capture financial frictions more appropriately, building on Bernanke and others (1999), a financial accelerator mechanism was also added on to these models (see for example, Cespedes and others, 2004; Devereux, and others, 2006; Gertler, and others, 2007; as well as Elekdag and Tchakarov, 2007).

With the growing feasibility and popularity of Bayesian method, building upon the closed economy studies of Smets and Wouters (2003, 2007), small open economy models were estimated (Lubik and Schorfheide, 2007; Teo, 2006; as well as Christensen and Dib, 2006). Then, Elekdag, Justiniano, and Tchakarov (2006) estimated a small open economy model with a financial accelerator for an emerging market, which later motivated others do follow suit using richer modeling structures (see, for example, Garcia-Cicco, 2010). Against this backdrop, this paper takes Elekdag, Justiniano, and Tchakarov (2006) as a starting point, and augments their model with some of the features in Gertler and others (2007), Smets and Wouters (2007) to improve model fit and to facilitate the counterfactual simulations discussed below.

II. Economic Developments in Turkey: The Role of Macroeconomic Reforms

By way of background for the rest of the paper, the main objective of this section is to briefly discuss some key developments regarding the Turkish economy over the last two decades.2 In particular, we would like to focus on a few key macroeconomic policy reforms that we argue helped soften the impact of the global financial crisis which intensified after the Lehman Brothers bankruptcy.

It will be useful to draw attention to the macroeconomic turbulence in Turkey during the 1990s (which included a financial crisis in 1994) as reflected in some selected macroeconomic indicators shown in Figure 1. How does the recent Turkish experience differ from the past? To address this question, we take the intense financial crisis of 2001 as our point of departure, which was associated with fragilities in the banking system and a speculative attack on the fixed-exchange rate regime in place at the time. A severe recession ensued.

Figure 1.
Figure 1.

Turkey: Selected Macroeconomic Indicators 1

(Year-over-year growth rates and levels)

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Sources: CBRT; Bloomberg; and authors’ calculations.1 Y, C, I, INT, INF, REER, and TB/Y denote real GDP, real consumption, real investment, overnight interest rates, quarterly inflation rates, real effective exchange rate and the trade balance-to-GDP ratio. EMBI represents JP Morgan’s EMBI+ series for Turkey (in basis points). The series with an asterisk represent foreign variables. Y, C, I, and Y* were all seasonally adjusted as was the CPI series used to derive the inflation rates. Y, C, I, Y*, and the REER were logged before the seasonal adjustment, and then their year-over-year growth rates were calculated.

After the 2001 crisis, Turkey embarked on a new IMF-supported arrangement. For the purposes of this paper, two major reforms that were implemented in the aftermath of the crisis are emphasized:

  • First, the heavily managed and fixed exchange rates regimes of the past were abandoned in favor of floating exchange rates.

  • Second, and relatedly, the CBRT started its transition, and in 2006, officially implemented a full-fledged inflation targeting regime which would serve as the economy’s nominal anchor.

Over the next 26 quarters, from the first quarter of 2002 to mid-2008, the Turkish economy grew by over five percent (year-over-year), and inflation declined markedly.3 While global economic and financial conditions were favorable, it is hard to argue that the reforms mentioned above did not contribute positively toward achieving these growth rates.4

With the intensification of the global financial crisis during the fall of 2008, synchronized downturns coupled with financial stress affected international capital markets and economies across the world. As expected, the Turkish economy was severely affected by this abrupt collapse of the global economy. In fact, the contraction in world demand hit Turkish exports with severe implications for the rest of the economy. At the same time, the shock to global financial markets resulted in a collapse of asset prices (including the currency), an increase in spreads, and sizeable capital outflows. In addition, the heightened uncertainty associated with the unprecedented nature of this global financial crisis reinforced the foreign demand and financial shocks as well as acted as another channel suppressing consumption, investment, and credit extension. Therefore, for the purposes of this paper, we argue that the Turkish economy was unfavorably affected by a collapse in foreign demand, distress across international capital markets, and heightened uncertainty.

As a result, Turkey was one of the hardest hit countries by the crisis. Real GDP contracted sharply for four quarters, reaching a year-over-year contraction of 14.7 percent during the first quarter of 2009, resulting in a –4.8 percent annual contraction. The CBRT grasped the implications of this dire situation relatively early on. Anticipating substantially reduced levels of resource utilization, and in an attempt to mitigate the impact of the crisis on the economy, the CBRT cut interest rates by an astounding 1025 basis points over the November 2008 to November 2009 period. But to what end? We seek to address this question below.

III. The Model

This section presents an overview of the structural model underpinning our quantitative results. As mentioned above, readers primarily interested in the main policy implications of the paper could directly proceed to Section VII and Section VIII. The goal here is to present the general intuition of the model, while the details are relegated to the Appendix. The structural framework builds upon a core (New) Keynesian model. The model used is an open-economy variant of what the literature refers to as a New Keynesian dynamic stochastic general equilibrium (DSGE) model. However, to better fit the data, the model is augmented with a number of features including real and nominal rigidities (including, for example, investment adjustment costs and sticky wages), as well as a financial accelerator mechanism (to capture financial market imperfections) among several others.5

The model consists of several agents including households, producers, and the government. There are three types of producers: entrepreneurs, capital producers, and retailers. The government is responsible for implement monetary and fiscal policy. A visual representation of the flow of goods and services across these agents is shown in Figure 2. However, rather than elaborate on all aspects of the model, this goal in this section is to focus on the transmission of certain shocks and the role of monetary (and exchange rate) policy.

Figure 2.
Figure 2.

Model Schematic

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.

The transmission of shocks

For the purposes of this paper, we argue that during the global financial crisis, the Turkish economy was unfavorably affected by a collapse in foreign demand, distress across international capital markets, and heightened uncertainty. To assess this assertion, we posit that in terms of our model, these disturbances are captured by an export demand shock, a sudden stop shock, and a (financial) uncertainty shock. We now review each of these in turn. Later, we actually provide quantitative evidence that appraises the relative growth contribution of these three shocks (as well as the other structural shocks) during the recession which intensified in the first quarter of 2009.

The export demand shock

The export demand shock, or perhaps equivalently, the foreign demand shocks propagates through the model via the market clearing condition below:

YtH=CtH+CteH+ItH+CtH*+Gt

Leaving aside differences in notation, this is basically the standard aggregate demand identity for home (domestically produced) goods, which posits that domestic output is equal to the sum of consumption of domestically produced goods (which is the sum of both household and entrepreneurial consumption, CtH+CteH), domestic investment goods, ItH, government expenditures, Gt, and exports, CtH*. Therefore, leaving the other details to the complete model description in the Appendix (which also describes import demand), a collapse in export (foreign) demand is simply represented by a decline in CtH*.

The sudden stop shock

Turkey’s experience during the global financial crisis was also associated with a reversal of capital inflows (a sudden stop in the parlance of Calvo and others, 2004), as well as a sharp depreciation of the exchange rate. To capture these interrelated disruptions, we augment the uncovered interest parity (UIP) condition with a shock as in many other papers as follows:

it=it*Et[St+1St]Φt

where it and it*, represent the domestic and international (gross) interest rates, respectively, St denotes the nominal exchange rate (Turkish lira per U.S. dollar—an increase represents a depreciation), Et is the expectations operator (conditional on information up to time t), Φt and is the sudden stop shock (also referred to an exchange rate shock, UIP shocks, and some other in the literature). Therefore, as in Gerlter and others (2007), a shock that triggers large capital outflows is captured by this exogenous terms which is appended to an otherwise standard UIP condition. This sudden stop shock would serves to capture an important dimension of the financial aspect of the recent crisis.

The (financial) uncertainty shock

The description of this shock warrants some background. In this model, the real cost of capital departs from the standard representation in other studies because of the existence of an external finance premium. Consider the equation below:

Et[Rt+1k]=χt(·)Et[Rt+1]

where we have that the real cost of capital, Rtk, is equal to the real interest rate, Rt, augmented by the external finance premium represented by the term χt(·). In turn, the external finance premium depends on the leverage ratio (assets scaled by net worth) of the entrepreneurs:

χt=χt(QtKt+1Nt+1)

Note that total assets, QtKt+1, depends on the price of equity, Qt, which is not sticky (by contrast to goods prices or wages). This implies that the leverage ratio is quite sensitive to asset price fluctuations.

The precise specification of the evolution of net worth, Nt+1, is complex (and shown in the Appendix), so here we use an abridged version:

Nt+1=ϱtVt+Wte

where Wte and Vt denote the entrepreneurial wage bill and the value of the firm, respectively. The (financial) uncertainty shock is an exogenous process, represented by the term, ϱt, which by construction has direct impact on the level of aggregate net worth and therefore the external financial premium. Put differently, the net worth shock could be interpreted as a shock to the rate of destruction of entrepreneurial financial wealth (in line with several other studies). This shock directly affects entrepreneurial net worth and has been used in various forms by Elekdag and others (2006), Curdia (2007), Christiano and others (2010), and more recently by Ozkan and Unsal (2010). Another way to think about this shock is that it could be thought of capturing counterparty risk—owing part to Knightian uncertainty—a key consideration during the global financial crisis. This heightened uncertainty regarding cash flows, for example, would impair assets and thus disrupt the financial system.

What role for monetary policy?

In our model, the central bank alters interest rates in an attempt to achieve certain policy objectives. Before proceeding to the details, note that the policy rule to be described below implies that the monetary authority sets the nominal interest rate, taking into consideration the inflation rate deviation from the time-varying inflation target, the output gap, the rate of exchange rate depreciation, and the previous period’s interest rate (policy smoothing).

A simplified version of the interest rate rule takes the following (log-linear) form (see Appendix for further details):

ι^t=ρiι^t-1+τπ(Etπ^t+1-ρπ¯π^tT)++τyy^t+τsΔs^t+ti

where, in this flexible specification, ι^t,π^t+1,y^t,s^t denote the (short-term policy) interest rate, the (core CPI) inflation rate, the output gap, and the nominal exchange rate, respectively. Note that ti denotes the monetary policy shock—interest rate changes that deviate from the (empirical) interest rate rule would be captured by this disturbances and could be considered discretionary monetary policy. The time-varying inflation target, π^tT, is assumed to evolve according to the following stochastic process:

π^tT=ρπ¯π^t-1T+tπ

The time-varying inflation target captures the reality that the inflation target in Turkey was changed over time. However, it has also been used in the literature to capture structural changes in the conduct of monetary policy that are not captured otherwise (see Adolfson and others, 2007, for further details).

Anticipating the results to follow, notice that when the output gap is negative—that is, output is below potential—strict adherence to the rule above would imply that the interest rate decreases by an amount dictated by the coefficient ιy. However, the monetary authority might decrease interest rates by more than what the systematic component of the rule would imply. Recall that this deviation from the rule is capture by the error term, ti, which is the monetary policy shock—thereby capturing discretionary monetary loosening. As will be discussed in further detail below, during the most intense episode of the global financial crisis, interest rates decreased by more than the amount the empirical counterpart of the rule would have implied, helping soften the impact of the global financial crisis.

IV. Estimation

This section gives an overview of model estimation. It briefly reviews issues pertaining to data, parameter calibration, the choice of prior distributions, the resulting posterior distributions, model fit, and sensitivity analysis. An extensive discussion of these issues is covered in the Appendix.

Data

The log-linearized model is estimated using Bayesian methods primarily developed by Schorfheide (2000), and later popularized by Smets and Wouters (2003, 2007). The model is estimated using quarterly data from the first quarter of 2002 to the second quarter of 2010 using the series shown in Figure 3. In line with many other studies, we have chosen to match the following set of twelve variables: the levels of the domestic policy and foreign interest rates, the inflation rates of domestic GDP deflator and core consumer price and foreign consumer price indices, as well as the growth rates of GDP, consumption, investment, exports, imports, foreign GDP, and the real exchange rate. The sample period used for estimation covering the 2002–2010 period under consideration captures the episode when the CBRT was transitioned to an inflation targeting regime (initially implicitly, and the explicitly starting in 2006).

Figure 3.
Figure 3.

Model Predictions versus the Data 1

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.1 Data in thick black versus filtered thin lines with circles, see text for further details.

Model Parameters

We followed the literature and calibrate certain parameters (see, for example, Christiano and others, 2010), which could be thought of as infinitely strict priors. Many of the parameters are chosen to pin down key steady state ratios, while the remaining parameters are taken from the literature as summarized in Table 2.

Table 1.

Turkey: Financial Ratios Across Selected Industries1

article image
Sources: CBRT; and authors’ calculations.

CR, ATO, NI, NS, ROA, and ROE denote the cash ratio, total asset turnover, net income, net sales, and return on assets and equity, respectively. Leverage is defined as total assets over equity and NI/NS is the net profit margin. Tabulated values denote industry averages. Averages across all sectors denoted with “All”. Descriptive statistics for major sector shown are below each section of the table.

Table 2.

Calibrated Parameters

article image
Source: Authors’ calculations.

The remaining 43 parameters, shown in Table 3, are estimated. These parameters determine the degree of the real and nominal rigidities, the monetary policy stance, as well as the persistence and volatility of the exogenous shocks. The table shows the assumptions pertaining to the choice of distribution, the means, standard deviations, or degrees of freedom. The choice of priors is in line with the literature.

Table 3.

Prior and Posterior Distributions

article image
Source: Authors’ calculations.

For the inverse gamma distribution, the mean and the degrees of freedom are reported in the table.

The posterior estimates of the variables are also shown in Table 3. The table reports the means along with the 5th and 95th percentiles of the posterior distribution of the estimated parameters obtained through the Metropolis-Hastings sampling algorithm. In general, the parameter estimates are in line with those found in other studies.

An initial assessment of model fit and sensitivity analysis

In terms of assessing the fit of the model, we start off by comparing the data with the baseline model’s one-sided Kalman filter estimates of the observed variables, and then consider model robustness in the following section. The data and the filtered variables are shown in Figure 3 indicating that the sample fit is generally quite satisfactory.

To assess the robustness of the estimated model, we consider a battery of alternative specifications which include different monetary policy rules and alternative structural features. The results are summarized in Table 4, which depicts the log data density of the various models, and the posterior odd ratio contrasting the baseline and the alternative model specifications. While the details are discussed extensively in the Appendix, the main takeaway is that we consider 18 alternative specifications, and the results are very strongly, if not decisively, in favor of the baseline.

Table 4.

Sensitivity Analysis

article image
Source: Authors’ calculations.

V. Model Dynamics

This section aims to explore the dynamics of the estimated model. It starts off by exploring the implications of a monetary policy shock, and then provides an overview of the dynamics associated with the other shocks relegating the details to the Appendix.

The monetary transmission mechanism

We start off by considering the monetary transmission mechanism in Turkey. This is critical because the focus of the paper is to assess the role of monetary policy during the global financial crisis.

To this end, we consider the impulse responses to a one standard deviation monetary tightening shock as shown in Figure 4. Also note that we compare models with and without the financial accelerator, to assess how financial frictions affect the monetary transmission mechanism. The shock propagation is effected via three main channels:

  • The first channel operates as interest rates affect domestic demand, which primarily comprises of consumption and investment. Working through the Euler equation, higher real interest rates foster an increase in saving as consumption is postponed to later periods. At the same time, higher real interest rates increase the opportunity cost of investment, decreasing the rate of capital accumulation (a channel that is operational in models with capital). As a result, domestic demand and output decreases, putting downward pressure on inflation.

  • The second channel brings out the open economy features of the model as it works via the exchange rate. Because of the nominal rigidities, the increase in the nominal interest rate translates into higher real interest rates and is associated with an increase in the real exchange rate. In turn, this appreciation of the real exchange rate suppresses net exports (the expenditure switching effect), further decreasing aggregate demand.

  • The third channel is characterized by the financial accelerator mechanism. Higher interest rates depress asset prices (the real price of capital) bringing about a deterioration in net worth. Weaker balance sheet fundamentals cause an increase in the external finance premium thereby raising the opportunity cost of investment above and beyond the initial effect generated by the monetary tightening. As indicated in Figure 4, this brings about an even sharper contraction in investment, which is the primary determinant of the deeper contraction. As is clear in the impulse responses, the financial accelerator mechanism can amplify the effects of certain shocks (as discussed in Bernanke, Gertler, and Gilchrist, 1999) and is further explored in the Appendix.

Figure 4.
Figure 4.

Dynamic Responses to a Monetary Policy Shock1

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.1 Interest rates, inflation rates, and the external finance premium are shown as absolute deviations from their steady states, while the other variables are percentage deviations from their steady states.

To more openly communicate the degree of uncertainty regarding the monetary transmission mechanism in Turkey during a sample period which encompasses the global financial crisis, Figure 5 presents Bayesian impulses response functions for a selected set of variables along with their 90 percent bands which take into consideration parameter uncertainty. As shown in the Table 3, a one standard deviation contractionary monetary policy shock corresponds to a 70 basis point (quarterly) increase in the nominal interest rate—in other words, an annual increase in the policy rate of about three percent. The impulse response functions indicate that the output gaps dips below the steady state by 70 basis points, whereas the year-over-year inflation rate reaches a trough of about 140 basis points below steady state after four periods.6

Figure 5.
Figure 5.

Turkey: The Monetary Transmission Mechanism 1

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.1 Interest rates, inflation rates, and the external finance premium are shown as absolute deviations from their steady states, while the other variables are percentage deviations from their steady states.

The model includes 15 structural shocks including the monetary policy shock discussed above. For the purposes of this paper, a detailed discussion of the impulse responses of the remaining shocks is relegated to the Appendix in order to proceed to the sections of the paper which presents our main results and policy implications.

VI. Historical Decompositions

This section seeks to better understand the contributions of the structural shocks to output growth. Of course, in line with the main theme of the paper, the key structural shock we will focus on is the monetary policy shock. In this context, the section will quantify the role of monetary policy shocks on output growth, and will therefore provide one of our main policy implications.

For the purposes of this paper, we categorize the 15 structural shocks in the model into three groups to reinforce intuition. The first group consists of the monetary policy shocks and is the focus of this section. The second group comprises the crisis shocks, namely, shocks to foreign demand, financial uncertainty, and the uncovered interest rate parity (the sudden stop shock), and the final group contains the remaining supply and demand shocks. Our goal here is to assess the role of these groups of shocks on (year-over-year) output growth over the 2005–2010 period, which includes the run-up and the most intense episode of the global financial crisis.

What was the growth contribution of the monetary policy shocks?

The main takeaway of this section is shown in Figure 6. The figure plots real (year-over-year, demeaned) GDP growth, as well as the growth contributions of the three groups of shocks described above. The figure addresses the following question: What was the growth contribution of the monetary policy shocks? The monetary policy shocks are shown in black, and as is clear from the figure, they positively contributed to output growth during the crisis episode.

Figure 6.
Figure 6.

Historical Decomposition: The Role of Monetary Policy

(Demeaned year-over-year real GDP growth and shock contributions)

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.

As we discuss in extensive detail in the next section, the average growth contribution of the monetary policy shocks during the crisis episode is about 1.1 percent. To put this number in perspective, recall that the year-over-year real GDP contraction in Turkey in 2009 was –4.8 percent. Without these monetary policy shocks, that is discretionary departures from the estimated interest rate rule, our model indicates that the growth rate for this year would have been –5.9 percent instead. In other words, monetary policy seems to have markedly contributed the softening the impact of the global financial crisis. We contrast this growth contribution of 1.1 percent to those in the literature in the following section below.

What was the role of the other structural shocks?

Consider first the role of the crisis shocks. To better understand the effects of the second group of shocks (foreign demand, risk premium, and financial uncertainty), each of these shocks is shown separately along with real (demeaned, year-over-year) GDP growth in Figure 7. To start off, however, note that the sudden stop (UIP or risk premium) shock does not seem to have an important effect on growth during the crisis. A key reason could be that in contrast to Cespedes, Chang, and Velasco (2004) as well as Elekdag and Tchakarov (2007) we follow the initial specification of Gertler and others (2007) and posit that entrepreneurs borrow in domestic- rather the foreign-currency denominated debt. This arguably could reduce the role of risk premium (UIP) shocks, an important determinant of exchange rate dynamics. However, given that foreign currency exposure in Turkey has generally decreased markedly after 2002, and because it was never as serious an issue as in some Latin American countries, for example, we do not pursue this (straightforward) extension in this paper, but leave it for future research.

Figure 7.
Figure 7.

Historical Decomposition: Crisis Shocks

(Demeaned year-over-year real GDP growth and shock contributions)

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.

The role of the crisis shocks depicted in Figure 7 could be analyzed in three phases. First there was the run-up to the global financial crisis. During the period starting around 2005, the positive contribution of the foreign demand shocks to growth starts gaining momentum. The healthy growth rate of the global economy that solidified in 2005 certainly is one reason why foreign demand seems to have supported Turkish growth during this period. Then, during the last quarter of 2008, emerging markets started feeling the brunt of the global crisis. According to the figure it was initially the financial uncertainty shock that negatively impacted Turkish growth, followed by the foreign demand shock. The last phase corresponds to the onset of the recovery lead by a decrease in the financial uncertainty shocks. We find that the financial uncertainty shock explains a large fraction of the downturn among the three crisis shocks. It is also interesting to note the lingering effects of the foreign demand shock. The depressed growth trajectory in our main trading partner—the Euro area—surely contributed these dynamics.

The growth contributions of the remaining supply and demand shocks are shown in Figure 8. The two prominent supply shocks are the unit-root and investment-specific technology shocks. In contrast to some other studies, there seems to be a limited role for the cost push (markup) and stationary technology shocks. By contrast, the unit root technology shock seems to be the most important of the supply shocks, echoing the result of Aguilar and Gopinath (2007) who argue that these types of trend shocks are important determinants of business cycle fluctuations across emerging markets. There also seems to be an important contribution by the investment-specific technology shocks, a point made by Justiniano and others (2010). The demand shocks consist of the government spending, preference, and time-varying inflation target shock. The latter has a negligible role, and the remaining two demand shocks usually tend to offset each other to varying degrees over time. Overall, we see that the net effect of these shocks acted as a drag on growth, particularly in the early phase of the global financial crisis.

Figure 8.
Figure 8.

Historical Decomposition: Other Supply and Demand Shocks

(Demeaned year-over-year real GDP growth and shock contributions)

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.

VII. The Role of Monetary Policy During the Crisis

In this penultimate section of the paper, we conduct some counterfactual experiments with the goal of answering the following question:

  • If the adoption of the flexible exchange rate regime and the implementation of active countercyclical monetary policy within an inflation targeting framework were not carried out, how much deeper would the recent recession been?

As will be discussed below, that answer is that the recession would have been significantly more severe. In fact, the counterfactual experiments we discuss below indicate that the countercyclical and discretionary interest rate cuts implemented by the CBRT within an inflation targeting regime underpinned by a flexible exchange rate added at least 3.2 percentage points to the 2009 real GDP growth outturn.

Before proceeding, it may be useful to recall that after the 2001 financial crisis, two monetary policy reforms were carried out: (1) the fixed and heavily managed exchange rate regimes of the past were abandoned in favor of a flexible exchange rate, and (2) the CBRT started implementing an inflation targeting regime—implicit initially, then officially as of 2006. Against this backdrop, while not the focus of the paper, as a by-product of our modeling setup, we can also take a first pass at assessing the possible role of the post-2001 financial reforms. As discussed in Section II, with these reforms the risk profile of the Turkish economy—lead by the banking sector—decreased markedly in the aftermath of the 2001 crisis. In terms of a summary indicator, consider the leverage ratio in Table 1. Based on a cross section of firms, the average leverage ratio decreased to a value of two in 2007 from a value of three in 2000. In an illustrative scenario we seek to quantify the role of these reforms by altering the steady state leverage ratio.

Setting up the counterfactual simulations

Therefore in what follows, we consider four counterfactual simulations and compare them with the actual realization which is our baseline. Under the baseline, the monetary policy framework operates under a flexible exchange rate regime, follows the estimated baseline interest rate rule which reacts to the output gap and allows for deviations from the rule (in the form of the monetary policy shocks discussed above). In this context, the four counterfactual experiments are as follows:

  • No monetary policy shocks: this counterfactual posits strict adherence to the baseline empirical interest rate rule. It is a simulation that excludes the monetary policy shocks, that is, the monetary policy shocks, ti, are all set to zero in this simulation. It serves to address the following question: What would the dynamics of output growth have been if the CBRT did not implement any discretionary policy (deviations from the interest rate rule) during the crisis? While the previous section answered this question, here we seek to underscore this result and provide further context.

  • No response to the output gap: under this counterfactual, the output gap coefficient in the empirical interest rate rule is set to zero (τy = 0). Furthermore, as these counterfactuals are “cumulative,” this scenario also sets the monetary policy shocks to zero. It serves to address the following question: What would the dynamic of output growth have been if the CBRT did not implement any discretionary policy and did not take into consideration the state of the output gap when formulating its policy decisions during the crisis?

  • Peg: in this counterfactual, the CBRT is assumed to implement a strict fixed exchange rate regime.7 Intuitively, monetary policy does not react to the output gap, and there are no discretionary deviations from the rule (which solely focuses on stabilizing the nominal exchange rate). Here we seek to address the following question: What would the dynamic of output growth have been if the CBRT was implementing a fixed exchange rate regime?

  • Peg with heightened financial vulnerability: under the last counterfactual, the CBRT is presumed to operate under a fixed exchange rate regime as above, but the leverage ratio is calibrated to correspond to the case where it equals three in line with the value in Table 1 during 2000.8 While not the main focus of the paper, out modeling framework allows us to construct such an illustrative counterfactual serving to address the following question: What would the dynamic of output growth have been if the CBRT was implementing a fixed exchange rate regime and the economy was financially more vulnerable?

Results based on the counterfactual simulations

Figure 9 depicts the level of real GDP with the first quarter of 2008 (the pre-crisis peak) normalized to 100 to allow the reader to better distinguish the (cumulative) effects of each counterfactual. The figure depicts (1) the actual realization of real GDP (the baseline scenario), (2) the counterfactual scenario without the monetary policy shocks, (3) the counterfactual scenario without the monetary policy shocks and with the output gap coefficient in the empirical interest rate rule is set to zero, (4) the counterfactual scenario with the fixed exchange rate regime (peg), and (5) an illustrative counterfactual scenario with the peg under heightened financial vulnerabilities.

Figure 9.
Figure 9.

Counterfactual Scenarios: The Role of Monetary Policy and Real GDP

(Levels)

Citation: IMF Working Papers 2011, 150; 10.5089/9781455270484.001.A001

Source: Authors’ calculations.

As clearly seen from Figure 9, the inflation targeting framework underpinned by a flexible exchange rate regime clearly softened the impact of the global financial crisis. More specifically, it is useful to discuss three main results:

  • First, as expected, output growth declines the most under the fixed exchange rate regime. The lack of the exchange rate to serve as a shock absorber decreases the resiliency of the economy to the shocks that ensued during the global crisis. Intuitively, the illustrative counterfactual experiment with heightened financial vulnerabilities, and thereby a more pronounced balance sheets channel, leads to an even sharper decline in output. These counterfactual experiments highlight the role of the exchange rate flexibility as well as financial reforms that promote the soundness of the financial system.

  • Second, giving weight to the output gap seems to have a more limited role, but that is to be expected as the estimated coefficient (of 0.02) is quite low. In other words, the interest rate rule coefficient implies a small systematic response of policy rate to output gap, and a large discretionary (nonsystematic) response as summarized by the expansionary monetary policy shocks which we discuss next.

  • Third, as discussed in the previous section, there is an important role for the discretionary departure from the interest rate rule, which helped soften the impact of the crisis. At first glance, while they may seem small, as we discuss in further detail in the next subsection, the role of these discretionary departures from the interest rate rule (the monetary policy shocks) are very much in line with the literature.

While our results suggest that the inflation targeting framework underpinned by a flexible exchange rate supported growth during the global financial crisis, clearly other policies also played a role. For example, it should be noted that we do not capture the direct effects of the liquidity measures enacted by the CBRT starting in the fourth quarter of 2008. Some of these policies include extending the terms of repurchase (repo) transactions, restarting foreign exchange auctions, and reducing reserve requirements on foreign exchange deposits (for further details, see Yalcin and Thomas, 2010). Moreover, fiscal policy is modeled along the lines of many other studies in this strand of the literature, and is admittedly cursory. Therefore, it is important to recognize that it might be possible that some of the contributions of expansionary fiscal policy and some of the liquidity measures implemented during the crisis (and not directly captured by our model) could have been attributed to the monetary policy shocks.9

How do our results compare with those in the literature?

We now focus on the growth implications associated with the counterfactuals discussed above. The main takeaways discussed above could have also been based using (year-over-year, demeaned) growth rates as shown in Appendix Figure 7. However, this section tabulates the precise contributions to growth under the various counterfactuals as shown in Table 5. The intention is for the table to focus on the most intense period of the crisis, but this could be open to interpretation. Therefore, in the context of the Turkish economy, we consider two alternative crisis episodes: 2008:Q4–2009:Q4 or 2009:Q1–2009:Q4.

Table 5.

The Role of Monetary Policy and Financial Reforms

(In percent)

article image
Source: Authors’ calculations.

Before investigating the details, it would be useful to clarify the information contained in Table 5. The values under columns show either the average or cumulative contributions to growth during these two episodes. It presents our results, as well as the results of Christiano and others (2007), the most closely related study to our in terms of conducting counterfactual experiments. The number of quarters in each episode and the quarterly cut in interest rates is also presented. Columns 1 through 5 indicate the incremental contribution to growth owing to the consecutive implementation of each policy. For example, consider the 2009:Q1–2009:Q4 episode. Under Column 4 indicates that reducing financial vulnerabilities added, on average, 1.45 percentage points to growth. In addition to this effect, the incremental growth contribution of adopting a flexible exchange rate regime, denoted under column 3, is 1.86 percentage points.

It would be useful to first compare the results in Table 5 with the literature. Turning our attention to column 1, we see that the average contribution of the monetary shocks (discretionary deviations from the empirical interest rate rule) to output growth of around one percent (1.14 or 1.18 percent depending on the episode chosen) lies in between the values found by Chrisitiano and others (2007) for the U.S. (0.75 percent) and the euro area (1.27 percent). The cumulative growth contributions also seem reasonable, and give some context on the role of monetary policy in terms of softening the impact of the crisis.

To more intuitively summarize the findings in the counterfactuals above, we focus on the most intense year of the crisis, namely 2009. As shown in Table 6, the actual growth rate for 2009 was –4.8 percent. Our model-based simulations suggest that if the CBRT had not departed from the empirical interest rate rule, growth would have instead been –5.9 percent, a difference of 1.1 percentage points. Furthermore, if instead of the inflation targeting regime, a peg was in place, the results imply a growth rate of –8.0 percent, a difference from the actual of 3.2 percentage points. In sum, without the adoption of the flexible exchange rate regime, and active countercyclical monetary policy guided by an inflation targeting framework, the impact of the recent global financial crisis would have been substantially more severe.

Table 6.

Measuring the Severity of Economic Contractions

(In percent; calculations relative to actual 2009 annual real GDP growth)

article image
Source: Authors’ calculations.

The appendix provides two other measures to gauge the severity of the recessions presented in the counterfactual scenarios. First, using the level of GDP, we show the differences in the peak-to-trough output contractions. Second, we consider the “area under the curve,” whereby the metric compares the annualized average output loss relative to the baseline. Both of these alternative measures are quantified in Appendix Table 1. Overall, whatever metric one prefers, it is clear that the adoption of an inflation targeting framework underpinned by a flexible exchange rate regime helped soften the impact of the recent global financial crisis.

VIII. Summary and Main Policy Implications

This paper develops and estimates a structural model using Turkish time series over the 2002–10 period corresponding to the Central Bank of the Republic of Turkey (CBRT)’s gradual transition to full-fledged inflation targeting. Turkey is an interest emerging economy case study because it was one of the hardest hit countries by the crisis, with a year-over-year contraction of 14.7 percent during the first quarter of 2009. At the same time, anticipating the fallout from the crisis, the CBRT decreased policy rates by an astounding 1025 basis points over the November 2008 to November 2009 period.

To this end, general question this paper seeks to address is the following: Did the monetary policy implemented by the CBRT help soften the impact of the recent crisis? However, we interpret monetary policy more broadly and therefore investigate the role of being able to implement countercyclical monetary policy within an inflation targeting regime underpinned by a flexible exchange rate regime. In this context, we seek to address the following question: If an inflation targeting framework underpinned by a flexible exchange rate regime was not adopted, how much deeper would the recent recession been? This paper finds that the recession would have been substantially more severe.

This finding is based on counterfactual simulations derived from an estimated dynamic stochastic general equilibrium (DSGE) model which includes a financial accelerator mechanism in an open-economy framework. These counterfactual situations allow us to quantify the differences in terms of growth between actual outcomes, and for example, a case where the CBRT did not implement any countercyclical and discretionary interest rate cuts.

The most intuitive way to communicate our quantitative results is by taking the growth rate during the most intense year of the global financial crisis, namely 2009, as our baseline. In this context, our counterfactual simulations indicate that without the countercyclical interest rates cuts implemented by the CBRT, growth in 2009 would have decreased from the actual realization of –4.8 percent to –6.2 percent. Moreover, if a fixed exchange rate regime would have been in place instead of the current inflation targeting regime (which is underpinned by a flexible exchange rate), the results show that growth in 2009 would have been –8.0 percent, a difference from the actual outcome of 3.2 percentage points. In other words, these simulations underscore the favorable output stabilization properties owing to the combination of countercyclical interest rate cuts (consistent with the inflation target) and exchange rate flexibility.

In sum, without the adoption of an inflation targeting framework underpinned by a flexible exchange rate regime, the impact of the recent global financial crisis would have been substantially more severe.

The Role of Monetary Policy in Turkey During the Global Financial Crisis
Author: Selim Elekdag and Mr. Harun Alp
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    Turkey: Selected Macroeconomic Indicators 1

    (Year-over-year growth rates and levels)

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    Model Schematic

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    Model Predictions versus the Data 1

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    Dynamic Responses to a Monetary Policy Shock1

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    Turkey: The Monetary Transmission Mechanism 1

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    Historical Decomposition: The Role of Monetary Policy

    (Demeaned year-over-year real GDP growth and shock contributions)

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    Historical Decomposition: Crisis Shocks

    (Demeaned year-over-year real GDP growth and shock contributions)

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    Historical Decomposition: Other Supply and Demand Shocks

    (Demeaned year-over-year real GDP growth and shock contributions)

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    Counterfactual Scenarios: The Role of Monetary Policy and Real GDP

    (Levels)