It is assumed that relatively high rates of inflation will result in weakness (depreciation) of a country’s currency on foreign exchange markets

It is assumed that relatively high rates of inflation will result in weakness (depreciation) of a country’s currency on foreign exchange markets.

• It is assumed that relatively high rates of inflation will result in weakness (depreciation) of a country’s currency on foreign exchange markets.

• Theoretical explanation for this relationship, is the Purchasing Power Parity model.

• Exchange rates will change by an amount which is equal to, but opposite in sign to, inflation differentials. Over the long term, the model assumes that:
• High inflation country currencies will weaken
• Low inflation country currencies will strengthen

During the decade of the 1990s, the Turkish Central bank expanded the country’s money supply at an alarming rate.

• During the decade of the 1990s, the Turkish Central bank expanded the country’s money supply at an alarming rate.

• For example, in 1996, the money supply grew at an annual rate of 130%

• In response to this inappropriate monetary policy, Turkey experienced hyper inflation during the 1990s.

• The CPI peaked at 106.3% in 1994.
• See next slide for data.

• One of the consequences of this hyper inflation was a severe depreciation of the country’s currency, the Turkish Lira.

• This was predicted by the PPP model.

• From an average of 9 Lira per US Dollar in the late 1960s, the currency eventually traded at approximately 1,650,000 per US Dollar in late 2002 and early 2003.

By 2004, the Lira had become the world’s smallest valued unit of currency.

• By 2004, the Lira had become the world’s smallest valued unit of currency.

• One lira was worth approximately 0.000000743971 US dollars (American terms).

• As one example, a chocolate bar would cost more than a million Lira!
• This situation necessitated the issuance of large denomination bank notes in Turkey (see next slide).

In 2004, the Turkish Government announced the introduction of a new currency to replace the old Lira.

• In 2004, the Turkish Government announced the introduction of a new currency to replace the old Lira.

• The new currency, the New Turkish Lira was issued on January 1, 2005.

• It was equivalent to 1,000,000 old Turkish Lira, or
• One New Lira was worth one million old one liras.

• Monetary policy, too, had become less expansionary, and as a result:

• Consumer prices had fallen to 8.6% by 2004.
• Interest rates were down from 90% in 1994 to 25% by 2004.
• And, over the short run, the exchange rate had stabilized (see next slide).