Practise explaining floating exchange-rate movements using interest rates, inflation, capital flows, confidence and current account pressures.
Sources for use with Section B
The economy of Turkey
Figure 1 Central bank base interest rate, January 2018 to December 2020
Figure 2 Rate of inflation, as measured by the Consumer Price Index (CPI), January 2018 to December 2020
Figure 3 Turkish lira–US dollar exchange rate*, January 2018 to December 2020
Extract A Currency depreciation
Turkey’s President, who controls the Central Bank of Turkey, is an opponent of high interest rates. He dismissed the Central Bank’s previous Governor in 2019, complaining that “he would not follow instructions on interest rates”. The Central Bank made a series of interest rate cuts after a new Governor was appointed. The President wanted a reduction in interest rates to encourage borrowing by businesses and consumers in order to stimulate Turkey’s rate of economic growth.
By contrast, some economists urged the Central Bank to raise interest rates to slow the pace of credit growth and to avoid a currency crisis. They argued that following the reduction in base interest rates, there was a further fall in the exchange rate of the Turkish lira against the US dollar. Turkey’s large current account deficit and capital flight have also contributed to the depreciation of the Turkish lira. Attempts to increase the external value of the lira while keeping interest rates low have reduced most of the Central Bank’s foreign currency reserves. Economists warned that the risk of a financial crisis in Turkey was growing.
In response, the new Governor of the Central Bank of Turkey raised the base interest rate. This increase indicated that the Central Bank was concerned about the weakness of the lira and a high rate of inflation. By December 2020 the base interest rate had increased to 17%. However, some economists argued that the Central Bank would need to raise the base interest rate further to support the weak currency.
Turkey’s long-term economic growth will depend on attracting foreign direct investment and establishing a stronger partnership with the European Union (EU) which is a customs union and common market. Turkey is an important partner for the EU on matters related to trade, investment and migration. Governments of many EU countries believe that they have an economic interest in developing a mutually beneficial relationship with Turkey.
With reference to Figure 3 and Extract A, analyse two factors, other than changes in interest rates, that may have led to a depreciation of the Turkish lira.