INFLATION TARGETING AND EXCHANGE RATE DYNAMICS: EVIDENCE FROM TURKEY

This paper examines the constraints on the dynamics of the US Dollar and the Euro exchange rates relative to the Turkish lira after the full fledged Inflation Targeting regime was adopted in 2006. Despite the floating exchange rate regime during our sample period, one source of these constraints remained to be the FX policy of the Central Bank as it did not rule out interventions in the FX market in the face of unhealthy price developments. We find that the thresholds specifications that allow the conditional variance as well as the conditional mean to vary between regimes exhibit different dynamics in each regimes and produce superior forecasts below the threshold levels of the model for both the Euro and the US Dollar than the forecasts produced by the random walk model. Therefore,we conclude that the free float exchange rate regime can only be supported above the threshold levels of the exchange rates in Turkey. However, this is not in conflict with the Inflation Targeting framework, as the parameters of the estimated SETAR-TARCH-M(1,1) model allow enough flexibility to the policy makers to focus on the stabilization of inflation rates around the target level while, at the same time, serve to the goal of reducing the volatility in the exchange rates.