Turkey 1991 - 2004: A Case Study of the Purchasing Power Parity

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Turkey 1991 - 2004 A Case Study of the
Purchasing Power Parity
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General PPP Observation

• It is assumed that relatively high rates of
  inflation will result in weakness (depreciation)
  of a countrys 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

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Background on the Turkey and the Lira

• During the decade of the 1990s, the Turkish
  Central bank expanded the countrys 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 countrys
  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.

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Turkeys Annual Rate of Inflation, 1991 - 2002
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Lira Exchange Rate 1991 2004 European Terms
(Inverted Chart)
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Lira in 2004

• By 2004, the Lira had become the worlds 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).

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20,000,000 Turkish Lira banknote
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Changing Currency Replacing the Old Turkish 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).

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New Turkish Lira, 2005- 2006 (Inverted Scale)
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New Turkish Lira, 2005- Present (Inverted Scale)