Inflation stabilization in Turkey : an application of the RMSM-X model

This paper reviews the theoretical framework of an inflation stabilization program. In the absence of price rigidities, a reduction in inflation simply implies finding a replacement for revenue lost from a decline in the inflation rate. In reality, backward-looking nominal contracts and credibility problems induce short-run costs, making a fall in the economic growth rate an inevitable part of inflation stabilization. The theoretical framework yields the specification of a few key behavioral equations to be implemented in the model. The author's simulation results show that even if a credible program is implemented, at least two years of negative per capita growth are needed to bring inflation down from its current levels to below 10 percent a year. The accompanying fiscal effort is great: the equivalent of a 40 percent increase in direct tax revenues if no other expenditure or revenue measures are taken. Scenarios that do not incorporate strong fiscal action do not succeed in permanently lowering inflation and lead to lower per capita GDP at the end of the decade than does the scenario of fiscal stabilization. Inflation in the Turkish context is costly because it reduces not only the level of productive investment but also its efficiency.