Exchange rate regime and fiscal stability: An application to Turkey

Date

1998

Author

Erol, Turan

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Devaluation may under some conditions inflict a capital tax on domestic bond holders and thus reduce the debt service burden. These conditions are the fully flexible domestic goods prices and the long-term maturity of government debt. A discrete devaluation will then lead to an instantaneous rise in the price level and promote fiscal stability by lowering the domestic debt stock in real terms. Otherwise, the desired reduction in domestic debt service requires an overshooting of the real exchange rate. The gradual appreciation phase following the overshooting thus generates an interest tax on the domestic currency debt. However, the need for a sustained real devaluation to generate a trade surplus might push domestic prices above the long-run equilibrium value of the purchasing power parity, leaving little room for overshooting. This may imply an unpleasant tradeoff between external adjustment and fiscal stability. We put the issue in the context of the Turkish economy, and examine, both historically and ex ante, the implications of the exchange rate policy for fiscal stability. Although the exchange rate regime since 1980 may be characterized as a managed float, its impact on fiscal stability has been variant. A basic observation is this: A lower (higher) real domestic interest rate or interest differential is accompanied by a steady real exchange rate depreciation (appreciation). Moreover, fiscal stability seems not to have benefitted from the exchange rate overshooting. When examining the implications of alternative exchange rate regimes for fiscal stability, an interesting finding is that maintaining a fixed exchange rate is only a temporary means for achieving the goal of fiscal stability.

URI

http://www2.feas.metu.edu.tr/metusd/ojs/index.php/metusd
https://hdl.handle.net/11511/108364

Collections

Department of Business Administration, Article