Question

“The currency crisis in Turkey is being exacerbated by a skyrocketing annual inflation rate, which by some estimates, exceeds 100 percent. Countries with high inflation rates relative to others tend to see their currencies depreciate. Over three weeks time, the Turkish lira has plummeted, with selling intensifying into Monday's record low of 7.24 lira per dollar after President Donald Trump on Friday said he would increase tariffs on steel and aluminum originating from Turkey. The escalating tariffs were a direct attack on Turkey's refusal to free jailed American pastor Andrew Brunson. (CNBC, August 14, 2018)”

“Since Turkey suffered an economic crisis of confidence in August – with its currency falling by some 25% that month – emerging markets around the world, from South Africa to Indonesia, have also experienced plummeting currencies and an outflow of foreign investment. Argentina, which had stabilized after a crisis earlier in the year, has fallen back into emergency mode, increasing interest rates to 60%. Its currency, the peso, has fallen by 45% in 2018 and 24% in August”. (World Economic Forum September 04, 2018) (500 Words)

a. The Turkish Lira fell over 60% against the US dollar since Erdogan became president of Turkey in 2014. Explain how such currency depreciation could lead to stagflation in Turkey. Explain clearly why a country’s currency depreciates when the country faces high relative inflation rates.

b. One of the main reasons of this capital outflow from countries like Turkey is the fact that the Fed has been increasing the US Interest rate, up to almost 3%. Explain why a higher American interest rate causes an outflow of capital in other countries?

c. The Federal Reserve has raised the interest rates already 3 times in 2019, and is expected to raise the federal funds rate by another 25 basis points at the end of the year. For what reason is the US President Donald Trump not happy with these rate hikes? Make sure you do thorough research and explain your answer properly.

Answer 1

( a ) Stagflation for an economy is said to take place when the country is troubled with both the economic issues- a rising inflation, and stgnation of economy with high unemployment and a fall in economic growth.

Due to various internal and external reasons such as political instability, increase in capital outflow due to a consistent increase in US interest rates, the Turkish currency, Lira has depreciated significantly. As we know a large scale depreciation of the domestic currency shows devaluation of the currency leading to considerably higher inflation in the economy. It happens because the same amount of money is less valuable than before. Due to its depreciation it would buy less amount of goods and services than before with the same amount of money which means a higher price level for goods and services in the economy.

( b ) US dollar is the most important currency in the world and is most frequently used by traders, businesses, and other people. US being the largest economy in the world and due to importance of its currency, is considered the safest haven for investment. Earlier the interest rates in the US were too low for investors to earn money. A consistent rise in GDP growth of the US economy has meant that the Federal Reserve, central bank of the US, has consecutively increased interest rates to slow down the overheating US economy, thereby leading to benign inflation regime. A higher expected profit from a higher interest rate has attracted capital from most of the developing countries, including Turkey.

( c ) A higher interest rate means a fall in money supply leading to gradual decrease in economic activities or GDP growth in the country and a fall in GDP growth means a higher unemployment leading to political costs for the leaders, in this case, for President Trump