erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Sustainable Disinflation Program in Turkey

Sabit Khakimzhanov (Bilkent University)
Erinç Yeldan (Bilkent University)

Abstract  

For more than a decade Turkey has experienced relatively high and very persistent inflation. In our paper we attempt to explain this phenomenon as a Markov perfect equilibrium in an economy populated by competitive agents (the bankers) and a benevolent sequentially rational government. The government chooses the level of money supply and the stock of public debt to sell to the bankers. Each individual banker decides whether to purchase the debt or not at the prevailing nominal interest rate. The government's inability to commit itself to a predetermined monetary policy results in an imperfect credibility of disinflation plans. We begin by considering a benchmark "open-loop" equilibrium with commitment. The optimal monetary policy in this equilibrium calls for setting the nominal interest rates to zero. Departing from this case, we characterize a no commitment, "closed-loop" equilibrium in which the bankers know government's future monetary policy as a function of the nominal debt and make individually rational decision to purchase it given the nominal interest rates. Further, we show that the presence of high debt, even mostly short term, results in sustaining an inertia of the present rate of inflation. We argue that in Turkey with its history of high inflation disinflation program must be perfectly credible in order to avoid the outcomes in which high nominal interest rates perpetuate themselves as a pessimistic Markov equilibrium. We show that for relatively high levels of inflation and low debt, the benefits of the disinflation are greater than the costs regardless of the market interest rate. For higher levels of debt, the benefits are greater than the costs only if the interest rate reflects the expectation of lower inflation. In the case when market is always pessimistic, the optimal disinflation İstanbul Üniversitesi the slowest.

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