Exchange Rate Movements, Inflation Expectations, and Currency Substitution in Turkey

IMF Working Papers, November 1, 1995

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Canonical URL: Exchange Rate Movements, Inflation Expectations, and Currency Substitution in Turkey

Empirical analysis of currency substitution in Turkey derived from a two-stage portfolio choice model.
A simple relationship is derived between:
- the share of foreign currency holdings in M2X, and
- movements in the exchange rate or inflation.
Estimation method: band spectrum regression, which allows removal of short-term cyclical components.
Main result: the relationship between currency substitution depends mainly on long-term movements in the exchange rate.
Inflation’s effect on currency substitution is not statistically significant.

Theoretical framework: two-stage portfolio choice model linking currency composition of money holdings to exchange rate movements and inflation.
Empirical approach: band spectrum regression to filter out short-term cyclical components from the data.
Key variables: share of foreign currency holdings in M2X, exchange rate movements, inflation (and inflation differentials as relevant).

Currency substitution in Turkey is driven primarily by long-term exchange rate movements.
The effect of inflation on currency substitution is not statistically significant in the estimated relationship.
Short-term cyclical components are removed using band spectrum regression to focus on long-term dynamics.

Policies aimed at reducing currency substitution should consider mechanisms that stabilize long-term exchange rate expectations.
Relying solely on inflation control may be insufficient to reduce foreign currency holdings if exchange rate expectations remain unfavorable.
Nominal anchors and measures influencing long-term exchange rate credibility could be more effective in affecting currency composition of M2X than policies targeting inflation alone.