Question

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.

Answer 1

Depreciation means the currency buys less foreign exchange, therefore, imports are more expensive and exports are cheaper. After a depreciation, we get:

• Imported inflation. The price of imported goods will go up because they are more expensive to buy from abroad
• Higher domestic demand. Cheaper exports increase the demand for UK exports. There is also a reduction in demand for imported goods, shifting consumption to domestic goods Therefore, there is an increase in domestic aggregate demand (AD), and we may get demand-pull inflation.
• Less incentive to cut costs. Manufacturers who export see an improvement in competitiveness without making any effort. Some argue this may reduce their incentive to cut costs, and therefore, we get higher inflation over the long term.

Therefore, a depreciation causes both cost-push inflation and demand-pull inflation. So depreciation of Turkish lira will lead to stagflation in Turkey.

A higher inflation rate in Turkey compared to other countries will tend to reduce the value of the Turkish Lira because:

• High inflation in Turkey means that goods increase in price quicker than the US goods. Therefore Turkey's goods become less competitive. Demand for Turkey exports will fall, and therefore there will be less demand for Turkish Lira.
• Also,Turkey consumers will find it more attractive to buy US imports. Therefore they will supply Turkish Lira to be able to buy dollars and US imports. This increase in the supply of Turkish Lira decreases the value of Turkish Lira.