## 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](https://www.imf.org/en/publications/wp/issues/2016/12/30/exchange-rate-movements-inflation-expectations-and-currency-substitution-in-turkey-1970)

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## Bibliographic details
- Authors: Fabio Scacciavillani
- Published: November 1, 1995
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451853414.001

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### Summary
- 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.

### Methodology
- 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).

### Findings
- 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.

### Policy-relevant implications
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/30/exchange-rate-movements-inflation-expectations-and-currency-substitution-in-turkey-1970_