This study analyzes the effect of monetary policy on inflation by using Sargent and Wallace’s approach. Their assumption is that tight monetary policy is more inflationist than the loose monetary policy in a condition which the public has to borrow. Then, the monetary policy implemented by Turkish Central Bank (CBRT) between 1987 and 2002 is evaluated. It is concluded that CBRT assisted in the rise of inflation by implementing tight monetary policy from 1987 to 1997, and it contributed to the fall of inflation by following relatively loose monetary policy after 1997. Moreover, since the money generation process of CBRT is subject to the foreign assets, it is revealed that CBRT does not have a monopoly power in controlling the inflation rate.
It is a well-know fact that financing public deficits through central bank sources is an inflationary process. Generating money without reciprocal equivalence is definitely inflationist. However, for an economy with public borrows, tight monetary policy is more inflationist compared to a flexible (loose) monetary policy. Although this judgement may not seem consistent, Sargent and Wallace proved that it is not efficient in preventing inflation by itself. Economic authorities responsible for monetary and fiscal policies should harmonise these two policies. Another important aspect of Sargent and Wallace’s study is that it demonstrates that tight monetary policy leads to higher inflation in the long-term compared to monetary financing in an environment with public deficit. Yet, this study focuses on why tight monetary policy is more inflationist than loose monetary policy without including long term effects.
The reason for such a study is, as Turkish economy commenced domestic borrowing in 1985, to investigate the policies followed by the authorities who though to be less inflationist with regards to CBRT. From 1985 to 2000 the dominant strategy which ruled the economic administration was as follow: monetary authorities who had failed to secure fiscal discipline or had been obliged to do so and who had seen the inflation as merely a monetary phenomenon, fearing from the monetarization of public deficit, tended to domestic borrowing which they thought it could prevent inflation and left the task of fighting inflation to CBRT. This time period will be evaluated within the theoretical framework presented.
Since the development of monetary base until 1997 would not keep abreast with the consumer prices, CBRT followed the monetary base. That was very much beyond the control of CBRT. Because CBRT emphasised both growth of monetary base and change in the components of it, CBRT preferred to enlarge the monetary base through funds obtained from Net Foreign Assets by decreasing the NDA. CBRT, especially in the period between 1989 and 1995, wanted to prevent its sources to be used in financing public, but it could not succeed. In this period, although NDA increased, the factor which hindered the growth of monetary base was the decrease in the foreign assets. There was also outflow of foreign assets due to both instability of Turkish economy and external factors (ERM Crisis, 1991 Gulf Crisis, 1994 Mexico Crisis and so on). Perhaps, if domestic assets had been used a little more than the outflow of foreign source, inflation could have been prevented to go up to higher level.
The monetary policy of this period in Turkey can be claimed to be monetarist view (Günçavdı, Levent, & Ülengin, 2000, 167–168). Because there was a consensus that utilisation of CBRT sources to finance public sector was inflationist (Ertel & İnsel, 1993, 239–312; Erçel, 1996, 15–20; Ülengin, 1995, 111–117). There was a grave compromise among Turkish scholars on prevention of public use of CBRT sources in this period. This view was put into practice with a protocol signed between Treasure and CBRT in 1997.
As Sargent and Wallace remarked, the general level of prices can be described as not only a function of quantity of money but also future quantity of money. In an economy where tight monetary policy is followed, economic units determine the prices considering the development of public borrowing and the possibility of monetarization of this debt. In this case, tight monetary policy is more inflationist. When the negative effect of foreign assets on monetary base is taken into account, CBRT implemented a tight monetary policy beyond its control in the period between 1989 and 1995 and in that years 1996 and 1997. From 1997 on, CBRT started following tight monetary policy through monetary programs and NDA decreased rapidly. But it just remained observant at inflow of NDA causing monetary base to grow faster than inflation. It even zeroed the compulsory turnover in 1998. While CBRT was trying to control NDA, the inflow of foreign source led to formation of looser monetary policy. To control the open positions in the banking sector, it limited its capital at 20% from September 1999 on. After this, 100% compensation for open positions was imposed. But, that these limitations were not complied with was found out after the crisis in 2000 and 2001 (Keyder, 2001, 1–18). What is important for this study is that monetary base grew faster than required by overriding the open position limits. Consequently, the general level of prices came down to 45% in this period.
As for the reasons of inflation in Turkey, the proposition that there is a complex network of reasons based essentially on public finance process has not been analysed in this study. Taking the public borrowing requirement as data, the effect of tight or loose monetary policy on the general level of prices has been searched. As a result, CBRT’s monetary policy which seemed loose with regards to NDA, when evaluated with regards to base money, became tightened and the general level of prices went up from 1989 to 1995, because of outflow of foreign source. When monetary policy is followed with respect to NDA, monetary base, even unwillingly, grew partly because of increase in inflow of net foreign source, so this means having followed a loose monetary policy. In this period the general level of prices increased considerably comparing to the former period.
