Fiscal Theory of Exchange Rate Determination: Empirical Evidence from Turkey

In this paper we empirically test the effects of fiscal and monetary policies on real exchange rates for Turkey for the period 1990-2003. The analyzed period is characterized by large budget deficits, high and variable inflation rates. To assess the effects of fiscal and monetary polices on exchange rate we estimate a 5-variable VAR model for budget deficits, money supply, exchange rates, output, and interest rate differentials. The results suggest that expansionary fiscal policy appreciates real exchange rate whereas the effect of monetary shock is statistically insignificant. Innovations in interest rate differentials and output also cause to appreciation of Turkish Lira. The results of variance decomposition suggest that the effects of fiscal policy on real exchange rates are more pronounced than the effects of monetary policy. Our results are consistent with fiscal theory of exchange rates