The Price Puzzle in Emerging Markets : Evidence from the Turkish Economy Using Model Based Risk Premium Derived from Domestic Fundamentals

The recent studies by Blanchard (2004) and Favero and Giavazzi (2004) imply that a tight monetary policy consistent with an inflation-targeting framework in emerging market economies could actually increase the price level due to the lack of fiscal discipline and the associated high risk premium. We extend their arguments in two ways. First, we introduce a semi structural model with time varying parameters, where the risk premium is ‘unobserved’ and is derived within the system. Such an approach fits better with the volatile nature of the emerging market economies by allowing us to track down the time-varying effects of macroeconomic dynamics on both risk premium and other related variables. Second, we obtain the impulse response functions and analyze the implications of a tight monetary policy on the risk premium. Taking the Turkish economy as our reference point, we find that the arguments of Blanchard (2004) and Favero and Giavazzi (2004) seem to be valid.