Abstract

Like many developing countries that liberalized their capital account, Turkey has been at the mercy of short term capital inflows accompanied by a continuous real appreciation of the domestic currency since 1989. Open foreign exchange positions and increasing foreign exchange related assets in residents' portfolios have been the inevitable side affect. The recent inflation targeting policy is claimed to have reversed this trend. However the currency substitution measure developed in this study suggests an alternative interpretation of the situation. Although the share of TL denominated assets in total monetary assets has been increasing relative to the share of foreign currency related assets, the liquidity services of TL denominated assets is in fact not increasing. In this study distinct measures of asset substitution and currency substitution, as opposed to the generic FCD/M2Y, are developed and the different degrees of liquidity provided by alternative monetary assets are distinctly measured. These AS and CS measures follow the conventional intuition as to their driving factors and suggest the existence of hysteresis in currency substitution in Turkey. From a policy standpoint, this provides evidence that targeting and decreasing the inflation rate alone may not be sufficient to overcome the structural problems of the economy that have been in the making for decades.

Keywords: currency substitution; asset substitution; Turkey; Divisia aggregates.

JEL Classification: E5, E6, F3.

Introduction

The widespread experience in most developing countries of the use of foreign currencies and foreign currency denominated assets has been an issue of vast academic interest since the 1970s.