Applied Economics, 2010, 42, 1077–1083

Are devaluations contractionary?

The case of Turkey
Mehmet Senciceka and Kamal P. Upadhyayab,*
a
Department of Economics, Yeshiva College, Yeshiva University,
New York, NY 10033, USA
b
Department of Economics and Finance, University of New Haven,
West Haven, CT 06516, USA

This article studies the output effects of currency devaluation in Turkey

using annual data from 1970 to 2004. An empirical model that
incorporates monetary, fiscal and other external variables in addition to
exchange rates is developed. Before estimating the model, time-series
properties of the data are diagnosed. Two forms of the model, one with
real exchange rate and the other with nominal exchange rate and relative
price level (foreign-to-domestic price ratio) are estimated. The results
suggest that devaluation is contractionary in the short run, expansionary in
the medium run and neutral in the long run, and the effects emanate from
nominal devaluation and not from the changes in relative price level.

I. Introduction demand for imported goods is inelastic, the high

Currency devaluation is primarily used to correct
chronic current account deficits. By raising the exchange
rate and increasing the relative prices of imports,
devaluation or currency depreciation switches demand
from imports to domestically produced goods. At the
same time, an increase in the prices of tradables feeds
into the general price level lowering real money balances
(M/P) and the aggregate level of expenditure. The
ensuing decline in prices of nontraded goods shifts
production towards higher-valued tradables and
demand towards less-expensive nontradables. The
resulting surplus of goods and higher net exports help
improve the current account. As such, a devaluation is
expected to have a favourable effect on the trade balance
within short to medium run.
The effect of devaluation on the level of overall
output is not as clear. Since 1970s, economists have
warned of the contractionary output effects (e.g.
Cooper, 1971; Krugman and Taylor, 1978).
Devaluation may be contractionary through at least
three channels on the demand side. First, if the
share of capital goods, intermediate goods and
essential consumer goods in a country’s total imports
will reduce demand for domestically produced goods.
Second, total expenditure will fall due to the real
balance effect. In the case of price rigidities, prices of
nontradables will adjust slowly to lower demand.
If the demand for nontradables decreases by more
than the rise in net foreign demand for tradables,
then total output will decline. Third, devaluation helps
tradables only if the higher price level lowers real
wages. This, however, may mean a redistribution of
income from wage earners, who have high Marginal
Propensity to Consume (MPC) to capitalists with low
MPC. The net effect will then be a contraction of
aggregate demand and output (Krugman and Taylor,
1978; Edwards, 1986; Lizondo and Montiel, 1989).
Devaluation may also have contractionary effects
on the supply side. First, it directly increases the cost of
imported inputs leading to a reduced aggregate supply.
Second, in an economy where financial markets are
not well developed, devaluation reduces real volume of
credit available (van Wijnbergen, 1986). This in turn

*Corresponding author. E-mail: Kupadhyaya@newhaven.edu

Applied Economics ISSN 0003–6846 print/ISSN 1466–4283 online ß 2010 Taylor & Francis 1077
http://www.informaworld.com
DOI: 10.1080/00036840701721208
1078
raises the domestic interest rates and the costs of
production. Third, because of collective bargaining
agreements and wage indexation, nominal wage
increases in high-inflation economies can actually
outstrip inflation causing a reduced supply of output
(e.g. Agenor and Montiel, 1996).
The empirical findings of the output effect of
devaluation are mixed. Connolly (1983) and
Gylfason and Schmid (1983), among others, find
devaluations to be expansionary while Gylfason and
Risager (1984) and Branson (1986) report contrac-
tionary effects. In his widely cited study based on
pooled time-series cross-section data from 12 devel-
oping countries, Edwards (1986) finds a small
contractionary effect in the first year that becomes
expansionary in the second year and neutral in the
long run. Using econometric methodology developed
by Wickens and Breusch (1988), Upadhyaya (1999)
finds that devaluation has a neutral effect in the
long run.
Some recent studies have examined the impact of
currency devaluation by incorporating real exchange
rate directly and alternatively by decomposing it into
nominal exchange rate and relative price level (foreign-
to-domestic price ratio). For example, Upadhyaya and
Upadhyay (1999) find that a devaluation generally did
not have any effect on output over any length of time
in the six Asian countries studied, and any effect
uncovered came from changes in relative price level
and not from nominal devaluation. In another study,
Upadhyaya et al. (2000) found currency depreciations
were usually contractionary in selected Latin
American countries, and that the contractionary
effect came from nominal exchange rate and not
from the relative price level. Upadhyaya et al. (2004)
reported short-run expansionary effects on output in
Greece and Cyprus between 1969 and 1998, which
emanated from both nominal devaluation and
changes in the relative price level.
In this article, we study the output effects of
currency devaluation in Turkey during a period
characterized by an extensive reform and liberal-
ization programme, two deep financial crises along
with three major and numerous smaller devaluations.
During this period, Turkey’s exchange rate regime
changed from fixed to managed float, then to
crawling peg and finally to free float.
Before the reform programme of 1980, Turkey
attempted to resolve its foreign currency shortages
through import restriction and import substitution,
which were subsequently replaced with policies
designed to encourage exports that could finance
imports. With this strategy, planners hoped for an
export-led growth over the long run. These goals were
pursued by means of a comprehensive package that
M. Sencicek and K. P. Upadhyaya
called for the devaluation of the Turkish lira and
institution of flexible exchange rates. A near 50%
devaluation of the lira was implemented soon after
the programme was announced; a ‘managed float’
exchange rate regime started in 1987 by which the
currency was continuously depreciated parallel to
inflation expectations.
A sharp and sizeable increase in the current account
deficit along with massive requirements for public
sector borrowing and, serious policy errors in financ-
ing the deficit culminated in the currency crises of
1994. Large-scale capital flight and the collapse of the
exchange rate forced the devaluation of the over
appreciated lira by 62% as part of the recovery
programme. Capital flows returned during 1995–1997
and the economy recorded three successive years of
growth in excess of 7%. During this period, the
Central Bank of Turkey (CBT) effectively pursued a
policy of stabilizing the real exchange rate and
avoiding currency appreciation. The capital inflows
decreased sharply after the East Asian crisis of 1997;
the fallout from the Russian crisis in 1998 and a
devastating earthquake in 1999 pushed the economy
into a deep recession. A currency crisis was averted
during this turbulent period. At the start of 1998, CBT
announced that the exchange rate basket (1 USD and
1.5 DM) would be increased steadily and in parallel
with the expected inflation rate.
The government launched a disinflation programme
in December 1999 with an inflation target that was
anchored to a pre-announced crawling peg set in terms
of a basket of 1 USD and 0.77 Euros. The value of the
basket was to increase parallel to quarterly inflation
rate targets that would decline with each quarter.
A symmetric, progressively widening band about
the central exchange rate would be introduced in
mid-2001 and a gradual shift towards a more flexible
exchange rate regime would begin.
The programme initially followed an expected path
with a surge of capital inflows despite lower interest
rates and an upturn in economic activity. During 2000,
the pre-determined path for the nominal exchange rate
had been followed, but the inflation target was
overshot by 15 percentage points. This resulted in a
significant appreciation of the currency in real terms,
and coupled with rising oil-import bill, increased the
trade deficit to an unprecedented 5% of the GDP. In
November 2000, disclosure of irregularities in the
banking system, disappointing inflation results for
October and unexpectedly high monthly trade deficits
among other factors led to the loss of confidence in the
programme, and massive capital flight ensued. A large
bailout by the International Monetary Fund (IMF)
and the government’s undertaking of fresh commit-
ments to help restore confidence in the banking system
Are devaluations contractionary in the case of Turkey?
helped to stabilize the currency and financial markets
and reverse capital outflows.
Rising public debt, high inflation and the continued
real appreciation of the currency cast considerable
doubt over the sustainability of the peg. In February
2001, an incident between the prime minister and the
president triggered a large-scale flight from the
Turkish lira with overnight rates reaching 5000%,
and liquidity drying up. The government was forced to
abandon the peg and to float the currency; the lira lost
30% of its value against the dollar within a single
day. The floating exchange rate regime along with
‘implicit inflation targeting’ monetary policy helped to
reduce inflation rate to single digits by 2004, for the
first time in over 30 years.
In light of the recent Turkish experience of several
planned and forced devaluations, this article studies
the effect of devaluation on output using annual data
between 1970 and 2004. Section II describes the data
and methodology; Section III presents the estimation
of the empirical model including the relevant tests
and the error correction model and discusses the
results; Section IV is reserved for summary and
conclusions.
II. Data and Methodology
The methodology of this study is based on Khan and
Knight (1981) and Edwards (1986). Khan and Knight
argued that economic activity in a developing country is
affected by a number of fiscal and monetary variables,
particularly, fiscal expenditure and prevailing money
market disequilibrium. In this model, their excess
money supply term is replaced with money surprise
term following Edwards (1986) and rational expecta-
tions literature. The model also incorporates terms-of-
trade changes, which can independently affect the level
of economic activity. Finally, based on Upadhyaya and
Upadhyay (1999) and Upadhyaya et al. (2000) and
Upadhyaya et al. (2004), two approaches are used to
examine the output effects of exchange rate changes.
First approach includes the real exchange rate
directly, as a change in the nominal exchange rate
affects output only if it results in a change in the real
exchange rate (e.g. Cooper, 1971). Since, the real
exchange rate is the product of the nominal exchange
rate and the relative price level (foreign-to-domestic
price ratio), if the price level changes at the same rate
as the nominal exchange rate, the real exchange rate
will remain constant and will have no effect on
economic activity. This method, however, ignores
any asymmetric influence that an initial jump in the
exchange rate may have on output in the face of a
1079
gradual rise in the price level. Hence, the alternative
version of the model decomposes real exchange rate
to allow for the detection of any effects that may
originate from a change in the nominal exchange rate
or in the relative price level. The empirical model
resulting from the preceding discussion has the
following equations at level form (Equations 1 and
2) and the first-difference form (Equations 10 and 20 ):
log yt ¼ b0 þ b1 log Gt þ b2 ½log M  log M t
þ b3 log TOTt þ b4 log RERt þ u1t ð1Þ
log yt ¼ b0 þ b1 log Gt þ b2 ½log M  log M t
þ b3 log TOTt þ b4 log E
þ b5 log RPRt þ u2t ð2Þ

log yt ¼ b0 þ b1
log Gt þ b2 ½
log M

log M t þ b3
log TOTt
þ b4
log RERt þ u3t ð10 Þ

log yt ¼ b0 þ b1
log Gt þ b2 ½
log M

log M t þ b3
log TOTt
þ b4
log Et þ b5
log RPRt þ u4t ð20 Þ
where,
is the first difference operator, y is aggregate
output, G is government expenditure,
log M is the
actual money growth in a year,
log M* is the
expected money growth in the year assuming
expectations are formed rationally based on
all available information. This variable is the
predicted values of
log M that is derived by
regressing it with its own lag for the past 2 years.
Thus, [
log M
log M*] represents the unexpected
monetary expansion. TOT is the Terms Of Trade,
defined as the ratio of export prices to import prices
expressed in foreign currency and normalized to 100
for the year 1980. RER is the Real Exchange Rate
defined as the nominal exchange rate (E, domestic
currency units per US dollar) times Relative Price
Ratio (RPR), the foreign-to-domestic price ratio
(World Price Index/Domestic Consumer Price
Index). The residual term u is the random error
term of the model.
The coefficients of log GE and log TOT should be
positive as increases in government expenditure
and terms of trade are expected to be expansionary.
The money surprise term will also have a positive
and statistically significant coefficient if rational expec-
tations hypothesis is valid. The coefficient of log RER
captures the effect of real devaluation on output.
If negative (positive) and statistically significant,
1080 M. Sencicek and K. P. Upadhyaya
Table 1. Unit-root test

ADF test P–P test

Variable Level FD Level FD

log y 2.716 3.593** 2.93 6.225***

log GE 0.62 4.167** 0.693 6.452***
log(MM)* 1.137 5.299*** 2.978 4.151**
log TOT 1.769 4.391*** 1.457 4.583***
log E 2.821 3.024 2.653 3.211*
log RER 1.788 4.363*** 1.549 4.472***
log RPR 2.576 1.559 2.181 1.992

Notes: ADF ¼ Augmented Dickey–Fuller test, P–P ¼ Phillips–Perron test, FD ¼ First Difference. Critical
values are derived from MacKinnon (1991).
***, ** and * denote significance at 1, 5 and 10% levels, respectively.

Table 2. Johansen’s cointegration test (variables: log y, log (MM*), log RER, log GE, log TOT)

H0 Likelihood ratio 5% critical value 1% critical value

r0 97.38*** 68.52 76.07
r1 49.56** 47.21 56.46
r2 18.60 29.68 36.65
r3 9.04 15.41 20.04
r4 0.78 3.76 6.65

Note: *** and ** denote rejection of hypothesis at 1 and 5% significance levels, respectively.

it will suggest that, ceteris paribus, devaluations
are contractionary (expansionary). If statistically
insignificant, devaluation is neutral to output growth.
Researchers have argued that a devaluation’s effect
can be different at different time horizons.
For example, Edwards (1986) finds that devaluations
are contractionary in the short run, expansionary in
the medium run and neutral in the long run.
Upadhyaya et al. (2004) find the effect to be positive
in the short run and neutral in the medium to long
run. To capture the effects of devaluation over
different time horizons, we include lagged values of
real exchange rate as well as nominal exchange rate
and relative price level. Since, the quarterly data of
the level of output in Turkey exhibits considerable
seasonality, we use annual data series from 1970 to
2004 taken from various issues of International
Financial Statistics published by the IMF.
III. Estimation and Empirical Results
Since this study uses time-series data, it is important
to test for the stationarity of the data series in order
to avoid spurious regression. Following Nelson and
Plosser (1982), first an Augmented Dickey–Fuller
(ADF) test is conducted using the constant term and
trend. The Phillips–Perron (PP) test (Phillips, 1987;
Phillips and Perron, 1988) is also conducted to ensure
the stationarity of the data series. The PP test uses a
nonparametric correction to deal with any correlation
in the error terms. As seen in Table 1, both tests
indicate that all of the data series except log RPR, are
all nonstationary at the level and stationary at the
first difference level. The variable log RPR is not
stationary at the level or at the first difference level.
However, the graph plotted to ensure its stationarity
suggested that it is stationary at the first difference
level.
After establishing the stationarity of the data,
Johansen’s cointegration test (Johansen, 1988;
Johansen and Juselius, 1990) is conducted with both
versions of equations in order to examine the long
run relationship among the variables in each
equation. The test results are reported in Tables 2
and 3. The cointegration test results for both versions
of the equations suggest that the hypothesis of no
cointegration is rejected. The existence of at least one
cointegrating vector indicates that a long-run
relationship among the variables exists. To capture
the dynamic relationship, following Engle and
Granger (1987), an error correction model is devel-
oped. This involves estimating the model in the first-
difference form and adding an error correction term
as another explanatory variable. The error correction
term is the lag of the estimated error term derived by
regressing the dependent variable with all the
Are devaluations contractionary in the case of Turkey? 1081
Table 3. Johansen’s cointegration test (variables: log y, log(MM*), log GE, log RPR, log E, log TOT)

H0 Likelihood ratio 5% critical value 1% critical value

r0 155.51*** 94.15 103.18
r1 86.94*** 68.52 76.07
r2 50.07** 47.21 54.45
r3 23.69 29.68 35.65
r4 6.78 15.41 20.04
r5 0.97 3.76 6.65

Note: *** and ** denote rejection of hypothesis at 1 and 5% significance levels, respectively.

independent variables in the model. The error
correction models developed are as follows:

log y ¼ b0 þ b1
log G þ b2
log TOT
þ b3
log RER þ b4
log RER1
þ b5
log RER2 þ b6
logðM  M Þ
þ b7 EC þ u

log y ¼ c0 þ c1
log G þ c2
log TOT
þ c3
log E þ c4
log E1
þ c5
log E2 þ c6
RPR þ c7
RPR1
þ c8
RPR2 þ c9
logðM  M Þ
þ c10 EC þ v
where EC in both versions of the equation are error
correction term and u and v are the random error terms.
The estimation of Equations 3 and 4 are as follows:

log y ¼ 0:003 þ 0:104
log G þ 0:26
log TOT
ð0:12Þ ð1:57Þ
 0:03
log RER þ 0:09
log RER1
ð0:71Þ
þ 0:003
log RER2
ð0:07Þ
þ 0:20
logðM  M Þ  0:66EC

ð1:74Þ
2
Adj: R ¼ 0:51, D:W: ¼ 2:12, F ¼ 5:61,
BreuschGodfrey ¼ 0:72, RESET F ¼ 1:05

log y ¼ 0:03 þ 0:12
log G þ 0:26
log TOT
ð0:84Þ ð1:77Þ
 0:04
log E þ 0:09
log E1
ð1:63Þ ð0:91Þ
þ 0:01
log E  0:03
log RPR
ð0:66Þ
þ 0:1
log RPR1 þ 0:06
log RPR2
ð0:91Þ
þ 0:11
logðM  M Þ  0:67EC

ð0:84Þ
Adj: R2 ¼ 0:50, D:W: ¼ 2:44, F ¼ 4:08,
BreuschGodfrey ¼ 1:99, RESET F ¼ 0:25 ð6Þ
Here ***, ** and * denote significant, respectively,
at 1, 5 and 10% critical levels.
The estimation of both the equations seems
satisfactory in terms of the coefficient of determina-
ð3Þ tion and the signs of the coefficients of the variables.
The D.W. and the Breusch–Godfrey tests indicate
that the estimations are not suffering from any
autocorrelation problem. The insignificant RESET
F statistics suggests that the estimations are not
suffering from any form of specification error. In
both versions of the equation, fiscal policy (change in
ð4Þ government expenditure) seems to have a significant
effect in the Turkish economy (in the first version of
the equation, it is significant at 13% level). As for the
monetary policy, the surprise change in monetary
policy seems to have a significant effect only in the
first version of the estimation. In the second version,
ð2:47Þ the coefficient of this variable is positive, but not
statistically significant. Overall, we cautiously argue
that the theory of rational expectation may hold true
ð1:80Þ in Turkey.
Interestingly, the magnitude of the coefficient of
TOT is same in both versions of the estimation and
statistically significant at the conventional level of
significance. This suggests that an improvement in the
ð3:64Þ
terms of trade of Turkish economy indeed is
expansionary, presumably through an increase in
ð5Þ the volume of export.
The main focus of this study are the coefficients of
ð2:16Þ
RERs in Equation 5 and nominal exchange rates (Es)
and RPRs in Equation 6. The contemporaneous
effect of RER is found to be negative, 1-year lag
effect of RER is positive and statistically significant;
2-year lag effect is also positive, but the size of the
ð0:34Þ coefficient is diminishing. Overall, the effect of RER
is initially negative, then becomes positive and starts
vanishing. This suggests that the effect of currency
ð0:66Þ
devaluation in Turkey is contractionary in the short
run, expansionary in the medium run and neutral in
ð3:22Þ the long run.
1082
In the second version of the estimation (Equation 6),
we see the same pattern with the nominal exchange
rate. One-year lagged effect is close to statistically
significant at 10% level and 2-year lagged effect is also
positive, but very small and statistically insignificant.
The effect is clearly vanishing. The relative price ratio
and its lags seem to have statistically insignificant
effects. From these findings, we conclude that what-
ever effect devaluation has on the economy, it is
coming from a change in nominal exchange rate, not
from any changes in the relative price ratio.
As expected, the error correction term carries
negative and statistically significant coefficients in
both estimations suggesting that the variables in the
model are indeed cointegrated, and any deviation
from equilibrium in the current period is corrected
over a period of time.
IV. Summary and Conclusions
This article studied the effect of devaluation on the
level of output in Turkey using annual data from
1970 to 2004. An empirical model that incorporates
monetary and fiscal and other relevant variables in
addition to real exchange rate was developed.
Because the real exchange incorporates both the
nominal exchange and the relative price level, two
versions of the model were estimated. The real
exchange rate was incorporated directly in the first
version; it was decomposed in the second version
in order to detect whether the effect on output
originated from nominal devaluation or changes in
the relative price level. Before estimating the model,
the time-series properties of the data were diagnosed
using unit root and cointegration tests. Unit-root
tests indicated that the data series were integrated of
order one (nonstationary at the level and stationary
at the first-difference level). In order to capture the
long-run dynamic relationship among the variables,
cointegration tests were conducted with both the
versions of the model and the null hypothesis of no
cointegration was rejected. Hence, error correction
models of both versions were developed and esti-
mated. In both versions, expansionary fiscal policy
and an improvement in the terms of trade seem to
have a positive effect in the level of output. Surprise
monetary expansion is positively related to output
level suggesting that the rational expectation hypoth-
esis may hold true in Turkey.
The main focus of this study is the coefficients of real
exchange rate, nominal exchange rate and the relative
price level. The estimated negative contemporaneous
effect of real exchange implies that real devaluation is
M. Sencicek and K. P. Upadhyaya
contractionary in the short-run. The positive effect of
its 1-year lag and the statistically insignificant effect of
2-year lag suggest that real devaluation is expansion-
ary in the medium run and neutral in the long run,
respectively. The same pattern is observed for the
nominal exchange rate. The contemporaneous and lag
effects of changes in the relative price level are
statistically insignificant. Based on these findings, we
conclude that, in Turkey, devaluations are contrac-
tionary in the short run, expansionary in the medium
run and neutral in the long run. Further, the effect
emanates from nominal devaluation and not from the
changes in the relative price level.
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