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Turkey 1991 - 2004: A Case Study of the Purchasing Power Parity. General PPP Observation. It is assumed that relatively high rates of inflation will result in weakness (depreciation) of a country’s currency on foreign exchange markets.

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general ppp observation
General PPP Observation
  • 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
background on the turkey and the lira
Background on the Turkey and the Lira
  • 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.
lira in 2004
Lira in 2004
  • 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).
changing currency replacing the old turkish lira
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).