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The original news article based on which this commentary is written can be found here.
In September, 2021, the Turkish central bank reduced interest rates by 5 percentage points. By early 2022, inflation in Turkey had soared to “20-year high”, at nearly 49%. Inflation is defined as a sustained increase in general price levels. It is measured using changes in the consumer price index, which is a measure of the prices of essential goods and services purchased by generic households in the economy. Turkey’s consumer price index increased by over 11% in the month of January alone.
Monetary policy is the process of the central bank stabilising business cycle fluctuations, and hence price levels, by modulating interest rates. Turkish president Erdogan has declared himself “an enemy of high interest rates”.
The Turkish public’s “ability to purchase basics” has deteriorated, as food prices rose over 55% in a year. “High inflation” would cause the real value of wages to decrease while the cost of living increases, distorting the public’s economic well-being. Well-being is about economic prosperity and quality of life.
The Turkish money market is represented by Graph 1:
Free market equilibrium forms at ‘F’. The central bank continued to lower the interest rates, from September 2021 to January 2022, from ‘A’ to ‘B’, by executing expansionary monetary policy. The monetary policy could be executed by lowering the minimum reserve requirement, selling pre-existing government bonds (open market operations), lowering the central bank’s minimum lending rate or engaging in quantitative easing. Consequently, the money supply ‘Sm1’ increases, and shifts rightward to ‘Sm2’.
Fischer’s quantity theory of money suggests that a decrease in interest rates would increase consumer and business expenditure, as saving in banks becomes less profitable (Chen, 2019). Furthermore, the lowered interest rates decrease the cost of borrowing, and increase the ease of accessing credit, for all economic actors. Accordingly, the quantity of money demanded would increase from ‘C’ to ‘D’. These factors increase the economy’s aggregate demand, which causes a rise in price levels.
Graph 2 represents the monetarist model for Turkey’s economy:
Initially, equilibrium occurs along the Long-run Aggregate Supply (LRAS) curve at ‘L’. The increase in direct expenditure and expenditure arising from more accessible credit shifts aggregate demand ‘AD1’ rightward, to ‘AD2’. Therefore, real G.D.P. increases from ‘I’ to ‘J’ and price levels increase from ‘H’ to ‘G’. This creates a temporary inflation gap, which is demand-driven, as it was “triggered by interest rate cuts”.
This gap improves well-being by reducing unemployment to levels lower than the natural rate and allowing consumption levels to exceed the Turkish P.P.C. Debtors are better-off, as with inflation, the real value of their debt decreases. However, extreme inflation in Turkey caused an “economic upheaval”, with detrimental effects on wellbeing. Imports of essential goods were now more expensive, causing costs of production to rise. The currency’s value would decrease. Domestic and foreign investors would become fearful, and social unrest may occur. Creditors would be worse-off as the real value of interest payments would decrease. Imports become expensive and there may even exist a supply-side shock.
Hence, the short-run aggregate supply (SRAS) may shift left, creating cost-push inflation, leading to lower real output and higher price levels, worsening economic wellbeing. This leftward movement is further supported by Turkey’s “actual inflation”, as reported by an independent institute, soaring over 114% annually.
The Turkish president aimed to shift SRAS and LRAS rightward, to match the rising aggregate demand, by lowering interest rates. It was expected that the increased supply of money would increase expenditure and hence firm profits would rise. Firms would then use these profits to support technological developments which would lower their production costs and shift SRAS and LRAS rightward. This would increase the well-being of Turkish consumers and businesses. However, this did not happen. The “currency crisis”, which may have lowered investor confidence, and the soaring monetary inflation may have prevented this rightward shift in supply curves, compromising the wellbeing of more people.
To “reduce the spiral of high inflation”, the central bank would have to immediately decrease the money supply. As interest rates are currently low (when the article was published), delaying the reduction in interest rates worsens the consequences of high inflation. By reducing the money supply, the ease of obtaining credit and the velocity of transactions in Fischer’s theory would reduce. This would lower consumer and business expenditure, which shifts A.D. leftward, back toward L.R.A.S. equilibrium at ‘L’ (Graph 2).
The price levels would then decrease, the real value of borrowed funds and wages would be restored, bringing about economic stability and ensuring the wellbeing of Turkey’s citizens. In parallel, short-run supply side policies could be undertaken. The government could execute contractionary fiscal policy, by reducing expenditure on infrastructure, reducing transfer payments and increasing taxes. However, these policies would also have adverse effects on wellbeing, especially affecting economically weaker sections of society.