MACROECONOMIC ANALYSIS OF TURKEYS CRISIS UNDER ERDO?AN: INTEREST RATES, INFLATION, AND EXCHANGE RATES

Question 1: Redland & Blueland PPP, Wages, and Real Exchange Rates
(a) Which country is more economically developed?
Blueland is more economically developed than Redland. Economic growth is manifested in increased productivity particularly in the trade goods sector which spurs increase in wages and income levels. The productivity of the tradable sector, A T 4 i s, of Blueland is 4 times that of Redland, A T= 1. Higher tradable productivity enables Blueland to pay more wages in its economy since the tradables are priced on world markets. This is in line with the Balassa-Samuelson hypothesis that higher development correlates with higher productivity in tradables.
(b) Equilibrium nominal exchange rate
Let denote the nominal exchange rate defined as units of Redland currency per unit of Blueland currency.
PT = E x PT*
Given: PT = 1 and PT* = 2
Solving:
1 = E x 2 = E = 0.5
Therefore, the equilibrium nominal exchange rate is 0.5 units of Redland currency in one unit of Blueland currency.
(c) Equilibrium wage rates
Redland:
w = PT x AT = 1 x 1 = 1
Blueland:
w* = PT* x A*T
= 2 x 4 = 8
Therefore, equilibrium wages are:
? Redland: w = 1
? Blueland: w* = 1
(d) Equilibrium prices of non-tradables
In non-tradables, prices are determined domestically by unit labour costs.
Redland:
PN = w/AN
Blueland:
P*N = w/A*N = 8/3 = 2.67
Thus, non-tradables are significantly more expensive in Blueland.
(e) Equilibrium real exchange rate
First, compute aggregate price indices.
Redland:
P = 0.5PT + 0.5PN = 0.5(1) + 0.5(0.5) = 0.75
Blueland:
P* = 0.5P*T + 0.5P*N = 0.5(2) + 0.5(2.67) = 2.33
The real exchange rate is:
q = (E x P*)/ P = (0.5 x 2.33)/0.75 = 1.56
A value greater than 1 indicates that Bluelands consumption basket is more expensive than Redlands in common currency terms.
(f) Why purchasing power parity does not hold
Purchasing power parity (PPP) is not true in this model due to the effect of productivity gaps between nations on the non-tradable prices as explained by the Balassa-Samuelson effect. Although the law of one price applies to traded goods through perfect competition and free trade, when a good is not traded internationally, it cannot be arbitraged, its price is set domestically (Akalpler, 2025). The increased productivity of Blueland in the tradable sector increases the wages of the whole economy as the labour is perfectly mobile between the tradable and non-tradable sectors within the country. Such an increment in wages raises the cost of producing non-tradable goods in Blueland, although its non-tradables sector is not notably more productive than in Redland. Consequently, non-tradables will cost a lot more in Blueland. Since aggregate price indices incorporate both non-tradables and tradables, high prices of non-tradables in Blueland will increase its aggregate price level as compared to Redland. In a common currency, this will result in having different real exchange rate therefore, PPP will not hold even with perfect competition and free trade in tradables.
Question 2: Pinkland: IS-LM-BP Analysis & Fiscal Policy
(a) Marginal propensities
From the consumption function:

the marginal propensity to consume (MPC) is 0.6.
From the import function:

the marginal propensity to import (MPM) is 0.1.
(b) IS, LM and BP curves
Goodsmarket equilibrium (IS) starts from with , , , and . Collecting terms gives

Moneymarket equilibrium (LM) is . With and , the LM schedule is .
Balanceofpayments equilibrium (BP) requires the current account plus capital flows to equal zero. The current account is . Setting and solving for yields .
(c) Initial equilibrium
The exchange rate is fixed at . Solving the system

gives , and . Output is 35 and the interest rate is 6%.
(d) Fiscal contraction with non-sterilised intervention
Government spending falls from 12 to 5 (a decrease of 7).
New IS curve

With the exchange rate fixed at S = 6.5:

From LM:

Solving simultaneously gives:

To support this equilibrium, the money supply must fall to:

Thus, under non-sterilised intervention, monetary contraction offsets fiscal contraction completely.
(e) Diagram 1: non-sterilised intervention

(Source: Akarsu, 2023)
The first effect of the fiscal contraction is a decrease in income and rates of interest. The decrease in interest rates leads to capital outflows straining the exchange rate. The central bank buys the foreign exchange to keep the peg constant leading to lower money supply in the country. This moves the LM curve to the left until the interest rate gets to the initial level. Consequently, the income and interest rates go back to the original levels (Akarsu, 2023). The policy is entirely effective in keeping the exchange rate constant but counteracts the impact of fiscal contraction on output.
(f) Fiscal contraction with sterilised intervention
Government spending falls from 12 to 5, so the IS curve shifts to . With the peg still fixed at 6.5 and the money supply unchanged, the LM curve remains . Solving gives and . The economy moves to lower output and a lower interest rate, and the central bank must sell reserves to finance the balanceofpayments deficit. The diagram illustrates the leftward shift of IS against an unchanged LM curve.

(g) Diagram 2: sterilised intervention

(Source: AKA, 2023)
In a sterilised intervention, the central bank counters foreign exchange transactions by open market operations, and the money supply is held constant. This means that the LM curve does not shift. Fiscal contraction reduces output and increases interest rates, leading to capital outflows. Such flows necessitate the need to lose foreign reserves to sustain the fixed exchange rate and hence, are unstable in the long run (AKA, 2023). The fiscal policy now has real contractionary effects on output as opposed to the non-sterilised intervention.

Question 3: Zabrowka: IS-LM-FX & Exchange Rate Overshooting
(a) Frankel equation BP-style curve
Given:

Also given:

Substitute:
So the y-intercept (in the axis) is:

That is exactly why the intercept is written that way: it comes directly from rearranging Frankels equation.
In this model, the exchange rate is pinned down by the interest differential relationship.
Notice that output does not appear in:

So for a given , is fixed regardless of . That makes the curve horizontal in space, meaning Zabrowka behaves like it has relatively free capital mobility (interest parity tightly links and ).

(b) Initial short-run equilibrium
1) LM curve (money market)
Given:

Substitute , :

2) Frankel equation (FX condition)
Given:

Substitute , , :

3) IS curve (goods market)
Given:

Substitute , :

Now substitute the FX equation into IS:

4) Solve LM and IS simultaneously to get
LM:
Substitute into :

Proven as required.
5) Get the initial
From LM:

6) Get the initial
From FX:

Final initial short-run equilibrium

(c) Money expansion to M = 19
Step 1: New LM curve
M = 19 = P + Y I => 19 = 4 + Y i => i = Y - 15
Step 2: Solve for new short-run equilibrium
IS curve: unchanged
Y = 15 i + 0.1 (S 1)
Frankel equation: unchanged (S depends on i)
S = 31 10i
Substitute into IS:
Y = 15 i + 0.1 (31 10i 1)
= 15 i + 0.1(30 - 10i)
= 15 i + 3 i
= 18 2i
LM: i = Y -15
=> Y = i + 15
Equate:
Y = 18 2i = i +15 = 18 2i = i + 15 => 3i = 3 => i = 1
Y = i + 15 = 16
S= 31 10i = 31 10 = 21
New short-run equilibrium: Y = 16, i = 1, S = 21
(d) Diagram 3: money expansion

(e) Long-run equilibrium with flexible prices
? Long-run output: Y = 12
? LM curve:
? IS curve:
? Frankel:
Step 1: Express IS in terms of i and S = P - 3 + 10(3 - i)

Step 2: LM:
Step 3: Frankel:
Long-run equilibrium:
(f) Diagram 4: Exchange rate overshooting
The exchange rate overshooting phenomenon is due to the fact that the financial markets are adjusted immediately as opposed to goods and money markets, which take time. An increase in the money supply causes the LM curve to shift towards the right and the interest rate to reduce. Reduction in interest rate leads to further depreciation of the currency beyond the long-run levels to achieve uncovered interest parity. The exchange rate consequently moves to a new steady state as an overshot level. The following diagram shows how jump depreciation would be at time zero, and how the exchange rate would gradually restore to its long-run level.

Question 4: Analysis of Turkeys Economic Crisis under Erdo?an
Since the presidency of Recep Tayyip Erdogan, the economy of Turkey has swung between boom and bust. Over ten years his government tried to achieve ultra-low nominal and real interest rates to stimulate credit-based growth. Negative real rates stimulated consumption and investment and at least temporarily provided high rates of rapid output growth, but they also triggered inflation and made the lira depreciate and the current-account deficit become wider. The low cost of credit stimulated imports, and the poor yield on assets in the lira stimulated capital outflows. Inflation was approaching 60 per cent by the end of 2022, the lira was falling and net foreign reserves were at very negative levels. The existence of a deposit-protection program, which paid back savers when the lira devalued, resulted in a huge contingent liability, which further weakened confidence.
A new finance minister initiated a stabilisation programme in order to prevent balance-of-payments crisis. He increased interest rates drastically and reduced government expenditure and in effect moved the LM curve towards the left and the IS curve downward. Increase in the rates decreased domestic demand, reduced the current-account deficit and attracted foreign capital which contributed to restore the reserves. The inflation dropped to 75 per cent to approximately 40 per cent and the exchange rate stabilised. The initial diagram below takes the IS-LM model to demonstrate that the low interest rates had taken the economy to a situation like (E1) where there was high output and low interest. Such changes cause the LM curve to shift upwards into (E0) which reduces output, but restores monetary stability.

The programme was put on hold following political events even though it had been fruitful at the beginning. In March 2025 with the arrest of a high-profile opposition leader, it caused protests and financial panic. The interest rate was again increased to protect the currency by the central bank burning foreign reserves and postponing recovery. The lending rates went to historic highs and bankruptcies increased. The AD-AS diagram below illustrates that repeated fiscal and monetary expansions had moved the aggregate-demand curve (AD) to the right and caused output to exceed potential and increased prices. The stabilisation involved retracing along the AS curve towards the possible output although the growth pressure by political interests complicated such adjustment.

The balance of payments was also distorted due to ultra-low interest rates. Domestic returns were forced to be low, and investors searched for returns where foreign countries offered more, and the current-account deficit increased with imports exceeding exports. The following diagram BP shows the way in which small open economies require high external balancing interest rates. The low rate policy in Turkey drove the economy off the BP curve as it required the reserves to be depleted and foreign borrowing to occur. By restoring the economy to higher rates, one causes the shift of the economy towards the upward-sloping BP curve, at the expense of decreased growth.

Rising inflation and a weakening currency were two vices that were strengthening each other. In uncovered interest parity, a low real interest rate means that the currency is depreciated to be expected to depreciate. With the devaluation of the lira, the cost of imports increased, and the rate of inflation increased. And our last diagram is a positive plot between the exchange rate and the rate of inflation: the greater the inflation, the worse the lira. As domestic political instability weakened the confidence, the lira plunged, increasing the inflation expectations, and compelling even more constrictive policy. The resultant stagflation (poor growth and high prices) has compromised the standards in living and the support of the government.