1. ¹University of Wisconsin-Milwaukee, USA
2. ²The Central Bank of Turkey, Turkey. E-mail: Ilker.Domac@tcmb.gov.tr

¹We thank Zafer Yükseler for very useful discussions and Ali Hakan Kara, Deren Ünalm as well as Erdal Ylmaz for their valuable contributions. We are grateful for comments from the participants in the 8th Dubrovnik Conference on Monetary Policy and Currency Substitution in the Emerging Markets. We particularly thank Jeffrey Miller, Paul Wachtel, and an anonymous referee for their detailed comments. The views expressed in this paper are those of the authors and should not be attributed to the institutions with which they are affiliated.

Abstract

This paper investigates the role of dollarisation in the dynamics of inflation in Turkey. Descriptive analysis suggests that, in addition to high inflation and economic instability, institutional factors also played an important role in the evolution of dollarisation in Turkey. The empirical findings corroborate the importance of dollarisation in the dynamics of inflation. The results suggest that shocks to dollarisation initially lead to a decline in the monetary base as the public switches from domestic to foreign money holdings. However, the monetary base increases later on to generate the required inflation tax for a given budget deficit. The findings also indicate that the fiscal authority tries to compensate part of the decline in inflation tax through raising administered prices. As expected, the exchange rate responds positively to shocks to dollarisation owing to the high elasticity of substitution between domestic and foreign currency.