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Macro lesson: What is the relationship between interest-inflation-exchange rate?

Monetary Policy Committee (MPC) of the Central Bank of the Republic of Turkey (CBRT), Prof. Dr. Met for the first time today after the appointment of Şahap Kavcıoğlu as Governor of the Central Bank. The Central Bank kept the policy rate constant at 19 percent. After the decision and declaration of the CBRT, the USD / TL rate exceeded 8.15.

Some economists say that the absence of the statement of “Additional adjustment measures can be taken if necessary” in the previous statements, which gave the message to the markets that there may be no more interest rate hikes and that the cuts of interest rates can be in the order, it is effective in the increase of the exchange rate.

It is a time course of interest rates in Turkey and generated debates about the effects on the exchange rate with inflation.

In traditional economic theory, keeping interest rates high is thought to have an effect on reducing inflation and strengthening the currency of the country in question.

In Turkey, Prime Minister Recep Tayyip Erdogan, opinion argues lowering interest rates to curb inflation.

International investors, in November, Turkey argues that it is based on the monetary policy implemented until the period in which the changes in the management of the economy and also shows that among the most important causes of the depreciation of the Turkish lira.

What is the relationship between interest and inflation?

There is a close relationship between inflation and interest rates. Interest is also among the factors that affect the exchange rate.

An attempt is made to establish a balance between the policies implemented and these.

One of the tools that the Central Bank has to manage the money supply in the market is the policy interest rates.

Changes in policy interest rates affect both the interest rates charged by banks and the value of assets such as bonds and stocks, since they modify the borrowing and borrowing costs of market players.

The level of interest rates determines whether individuals and institutions direct their resources to save or to spend.

For example, in an environment where interest rates are low, the tendency to spend increases because the income from saving is also low.

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Therefore, lower interest rates are expected to increase consumer spending and support economic growth.

However, rising consumer spending carries the risk of rising inflation.

Another problem is that the growing tendency to borrow and lend in an environment where interest rates are low causes the amount of local currency in the market to increase. This is another factor that generates inflation risk.

Therefore, in generally accepted economic theory, there is an opinion that keeping interest rates low will create inflation and that interest rates must be increased to contain price increases in a period of rising inflation.

What is the opinion that if the interest rate is reduced, inflation will decrease?

President Erdogan is among those who support the vision of the economy, which goes beyond traditional stereotypes that if interest rates are lowered, inflation will also decline.

Erdogan delivered a speech in Istanbul in January on the economy: “I need investment, employment, production, export. If these four titles are missing, there is nothing, we will brag about it. “The main job is to lower inflation by lowering the interest rate,” he said.

This view, also advocated by Erdogan, is based on a theory developed by the economist Irving Fisher, who lived in the late 19th and early 20th centuries.

Fisher’s theory is based on a formula that takes into account nominal interest, real interest, and inflation expectations.

  • Nominal interest: Interest rate applied in the market that is not free from financial movements of money depreciation.
  • Real interest: Nominal interest rate adjusted for the effect of inflation
  • Expected inflation: The rate of price increase calculated for a specified period in the future based on price movements.
  • Real interest = (1 + Net nominal interest) / (1 + Expected inflation) -one
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According to this formula, the sum of the real interest rate and the expected inflation rate is assumed to be equal to the nominal interest rate.

In an article he wrote about the reasons behind Erdogan’s approach, Cemil Ertem, Chief Advisor to the Presidency of Economic Policies, stated that, based on the formula developed by Fisher, there is no inverse, but correct, correlation between inflation and interest rates. .

Ertem wrote in the Daily Sabah newspaper in May 2018: “According to this, an increase in the nominal interest rate with the assumption that the real interest rate will remain constant in the long term means that there will be an increase in the expectations of inflation. In summary, according to Fisher’s formula, it is clearly seen that there is a correct correlation between interest rates and inflation in the long term ”.

What is Fisher’s formula?

  • I ≡ r * + π
  • nominal interest rate = real interest rate + inflation
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In the same article, Ertem argued that the 2008 crisis revealed that the traditional view was not correct.

In his article, Ertem also stated that a “neo-fischerista” movement has emerged in different parts of the world, in which academic visions and studies have been carried out in different parts of the world.

Especially after the 2008 crisis, there were some economists, including US Central Bank officials, who defended Fisher’s approach and said that monetary policies should be adjusted accordingly.

However, it has been pointed out that there is no concrete example that shows that this formula is valid if it is put into practice until now, while the traditional view of the interest-inflation relationship continues to guide monetary policies in both developed and global countries. growth.

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How does the exchange rate fit into this equation?

Along with the exchange rate, inflation and interest, it is the other side of the triangle. This section, especially in countries of great importance in terms of production, is due to the large proportion of imported inputs such as Turkey.

As increases in the exchange rate raise costs for producers, it is also reflected in selling prices, causing inflation to rise.

Economists Aegean Cansen, in an article they wrote in the Hurriyet newspaper in 2006, beyond the balance between supply and demand of countries like Turkey, also pointed out that the exchange rate has a significant impact on inflation.

Get tired of “the soft money in that currency without a country like Turkey, inflation ‘devaluation-inflation’ because it becomes sticky spiral. Price increases will not slow down without slowing down exchange rate increases. Therefore, these countries decelerate inflation by lowering the exchange rate, not cooling the economy. For this, you pay high interest in your national currencies and attract hot money to your countries. “With the fall of the exchange rate due to the increase in the supply of foreign exchange, price increases indexed to the price of the currency slow down,” he wrote.

In the generally accepted view, investors’ desire to “invest and hold” in that country’s currency plays a determining role in the course of a country’s exchange rate.

In this perception of investors, in addition to economic factors such as the country’s strong macroeconomic balances, factors that affect confidence and risk factors such as political stability also take on great importance.

It is also accepted that those who invest in a country’s currency want to get a return on it.

At this point, real interest, which shows the difference between the “nominal interest” determined in the market and the inflation rate, emerges as an important concept.

For example, countries that want to attract investors to their own currency must pay interest above the rate of inflation to make the investment attractive.

Full publication here.

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