Effectiveness of monetary policy under different levels of capital flows for an emerging economy: Turkey

Abstract

This article assesses the effect of tight monetary policy on economic performance under different levels of capital flows. Empirical evidence from Turkey between 1990 and 2013 suggests that tight monetary policy measured with a positive innovation on interest rate appreciates the Turkish Lira and decreases output and prices. However, the effectiveness of monetary policy decreases for interest rate and increases for exchange rate and prices if capital flows are high. Specifically, interest rate, local currency value of foreign currency and prices will be lower for higher levels of capital flows. However, the relative effectiveness of monetary policy on output is virtually unchanged.

Keywords:

• monetary policy
• capital flows
• interacted VAR

JEL Classification:

• E52
• F21
• F32
• F41

Acknowledgement

We would like to thank Sebastian Weber for sharing the PIVAR codes and Rana Nelson for her valuable suggestions.

Notes

¹ We deflate the portfolio investment with the lagged (rather than the current) value of the interpolated GDP to avoid simultaneity bias.