THE NEXUS BETWEEN NOMINAL INTEREST RATE AND EXCHANGE RATE. THE CASE OF TURKEY (1987-2016)

Abstract

The study critically sifted the nexus between nominal interest rate and exchange rate and factors that determines the exchange rate fluctuations and its impact on the nominal interest rate in Turkey. The research employed a time series data spanning from 1987 to 2016. The key time series and econometric model adopted to obtain the set objectives were the Impulse Response Function (IRF), Variance Decomposition and Granger Causality test. The macroeconomic variables employed in the analysis were the nominal interest rate, exchange rate, broad money supply (M2), GDP deflator and inflation deflator. The results reveals that the impact of shocks is not totally consumed overtime. This means that the variables do not return to their equilibrium level after the occurrence of the error term. Thus an increase in nominal interest rate at the beginning period leads to the depreciation of the foreign currency, which hinders exports and leads to a decrease in domestic production. The decomposition of Choleski shows that the exchange rate contributes little in determining the interest rate on the Turkish domestic market. However, the Granger causality test indicates that broad money supply (M2) causes the interest rate. Meaning that any increase in interest rate leads to a decrease in money supply in circulation. In order to remedy the excessive depreciation of the Turkish currency, the monetary authorities must increase the interest rate in the very short term. This would attract foreign capital and reduce inflation through a reduction in the supply of money in the market.