As the government of Türkiye has decided to lower the interest rate (Pitel, 2022), one important question that arises would be: what is the impact of the decision on the Türkiye economy? To answer the possible effect on Türkiye’s economy, the IS-LM theory in international macroeconomics can be applied as an explanation as it is a relatively simple model linking the relationship between goods, foreign exchange, and the money market. Hence, the IS-LM model could represent, explain or predict the performance of an economy. Türkiye adopted a floating exchange rate regime under which exchange rates are determined by supply and demand conditions in the market. Based on the IS-LM theory, the decline in Türkiye’s interest rate under a floating exchange rate may lead to a depreciation of the Lira, and an increase in its trade balance, investment, and total output.
In the domestic goods market, a lower interest rate could have a positive effect on the demand and an upward shift on the demand curve through an increase in investment, resulting in more output in the economy assuming ceteris paribus. The decline in interest rate makes investment less expensive, hence, it poses an increasing effect on domestic investment. However, it also means that the domestic market becomes less attractive for investors as the domestic expected return decreases. Assuming foreign return constant, the decline in domestic return would lead to an increase in the exchange rate of the Lira, meaning a depreciation of the Lira against the US dollar in the foreign exchange market. If this is the case, assuming all else equal, it can also be expected that the trade balance of Türkiye might experience an increase as the relative price of Türkiye to the rest of the world’s goods is lower in the global market that could bolster its export value.
Nevertheless, it is important to acknowledge that the IS-LM theory has certain limitations. First, it is applicable only to a short-term examination under certain assumptions, such as sticky prices and constant foreign economic circumstances, which may not always be practical in reality. Second, it fails to account for the potential repercussions of a liquidity trap in the long run. However, one cannot rule out the possibility of a liquidity trap arising, given the Turkish government’s intention to reduce its interest rate in the future. Since this theory has its constraints, it is necessary to supplement the analysis with additional theoretical frameworks to investigate the impact of Türkiye’s decrease in interest rates, especially in the long run.
First, the Fisher Effect concept can be applied to forecast that the current situation in Türkiye may lead to a further depreciation of the country’s currency, the Lira, over the long term. As prices adjust over time, inflation is likely to occur. The Fisher Effect posits that the nominal interest rate differential is equal to the expected inflation differential. Given that Türkiye’s interest rate is one of the lowest real interest rates worldwide, a reduction in interest rates is expected to result in a higher expected inflation differential with the rest of the world, leading to further depreciation of the Lira relative to the US dollar.
Furthermore, the lower interest rates may encourage Turkish citizens to hold their money in cash since there is no opportunity cost of holding money, making cash more attractive. According to the standard model of real money demand, a decrease in the nominal interest rate leads to an increase in the overall demand for money, which can result in a higher price or inflation when the growth rate of money is higher than that of real income, assuming all else equal. Additionally, if Türkiye maintains a loose monetary policy in the long run, it can be expected that the Lira will continuously depreciate, with the expected rate of depreciation equivalent to the interest differential at that time.
Second, it is worth noting that the liquidity trap could explain the effect of Türkiye’s interest rate decline if the intention to keep lowering the interest rate is implemented. This concept suggests that when a policy drives the interest rate hit the zero lower bound (ZLB), the central bank’s capacity to lower the policy rate further is exhausted. As per the case of Türkiye, the government wanted to keep applying downward pressure to market rates to calm financial markets. This policy may lead to a liquidity trap when Türkiye’s interest rate reaches zero or the ZLB if it continuously lowers its interest rate, which in turn leaves the monetary policy ineffective in intervening in the market. In this case, fiscal policy instead could be effective as it may boost the total output of the economy without crowding out effect.
In conclusion, the IS-LM theory could be utilized to examine the consequences of the Turkish government’s decision to reduce interest rates on Türkiye’s economy, but it is necessary to incorporate other theoretical frameworks to assess the long-term implications and the possibility of a liquidity trap if the interest rates continue to decrease. In the short term, the reduction of interest rates in Türkiye is likely to have an impact on the economy, leading to a depreciation of the Lira, and an increase in the trade balance, investment, and overall output. However, in the long run, as the price level adjusts, inflation and further depreciation could occur, leading to a potential liquidity trap when the interest rate reaches the zero lower bound.
References
Feenstra, R.C., & Taylor, A. M. (2016). International Macroeconomics (4th ed.). Worth Publishers.
Pitel, L. (2022, 8 June). Turkish Lira’s Slide Accelerates as Erdoğan Vows to Continue Slashing Rates. Financial Times. https://www.ft.com/content/4f56465e-d315-4502-b117-6dbd833e02e7
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