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A Turkey Float
Subject Monetary Policy
Topic International Finance
Key Words Exchange Rates, Investment, Economic Growth
News Story

The lira, Turkey's national currency, will now be determined by market forces rather than being pegged to a mixture of the U.S. dollar and the euro. The Turkish government's decision to float its currency resulted from a developing financial crisis that has seen interest rates soar and stock prices plummet. The market's response to the devaluation was to reduce the price of the lira about 25 percent. Analysts expect there to be little impact on other economies as a result of Turkey's devaluation.

Turkey's gross domestic product decreased by 5 percent in 1999. Its inflation rate is 65 percent. In light of these economic problems, Turkey sought International Monetary Fund help in the form of a $7.5 billion emergency loan in order to put in place economic reforms that would control Turkey's inflation and stimulate growth. The government's efforts to reduce inflation included measures aimed at reducing government spending and corruption in the banking sector. The decision to float the lira will, however, have adverse affects on inflation. The sharp rise in the lira increases import prices and reduces the incentive for domestic producers to hold down price increases.

The decision to float the lira was the result of a more immediate need to control the outflow of foreign investment capital from Turkey. Turkey's central bank had lost $7.5 billion of its cash reserves earlier in the week as a consequence of investor flight and a need to support its commercial banks. Turkey's banking sector has been suffering from falling profits and widespread corruption. There is a concern that the floating lira may weaken the banking sector even further.

Of concern to the U.S. is the possible spread of Turkey's problems to other emerging markets. The loss of confidence in the Thai bath in July 1997 and the resulting investor flight caused a financial crisis that spread throughout Asia. Turkey does not have a significant share of emerging-market debt nor does it trade with many other emerging-market countries and consequently, most emerging-markets experts believe that the events in Turkey will not have a continuing effect on other markets.

(Updated April 1, 2001)

Questions
1. In response to the Turkish government's decision to float its currency, the lira decreased in value relative to the dollar by 25 percent? What does this imply about the relative demand and supply of Turkish lira both before and after the float?
2. What impact will the decision to float the lira have on the prices of imported goods? Explain your answer.
3. Why do experts believe that Turkey's problems will not spread to other emerging markets??
Source Douglas Frantz with David E. Sanger, "Turkey Floats Currency, and It Falls 25%," The New York Times, Febraury 23, 2001.

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