REVISITING ThE RELATIONShIP BETWEEN EXChANGE RATES AND OUTPUT WIThIN SVAR BLANChARD-QUAh fRAMEWORK : EMPIRICAL EVIDENCE fROM TURKEY , GERMANY AND RUSSIA oGuzHan ozceLeBi

It seems important to determine the effects of exchange rate fluctuations on economic performance. In this study, we attempt to shed some light the relationship between industrial production difference and exchange rates using two Structural Vector Autoregression (SVAR) Blanchard-Quah models for the cases of Turkey and Germany and Turkey and Russia. Results from the impulse response functions (IRFs) and forecast error variance decompositions (FEVDs) of the two SVAR models emphasized that effects of nominal exchange rate on industrial production difference and real exchange rate are temporary. Nevertheless, macroeconomic policies of Turkey, Germany and Russia influencing nominal exchange rates should be examined seriously for explaining the variations in industrial production difference and exchange rates. keywords: exchange rates, industrial production, economic activity, SVAR model JeL classification codes: f31, f41, f43. INTRODUCTION In the wake of economic globalization phenomena, financial liberalization and economic integration have increased while volumes of foreign trade among countries and capital flows have also expanded. On the other hand, fluctuations in macroeconomic variables such as exchange rates, net exports, foreign reserves, monetary aggregates, price levels and output levels have ascended particularly in the severe crisis periods of new globalization era. Among all macroeconomic variables, effects of changes in nominal and real exchange rates on macroeconomic conditions have become important due to the integration of financial markets and acceleration of capital flows. The end of the Bretton Woods 1 Istanbul University, faculty of Economics; E-mail: ogozc@istanbul.edu. tr 2 Istanbul University, faculty of Economics; E-mail: nurtacy@istanbul.edu. tr ECONOMIC AND BUSINESS REVIEW | VOL. 13 | No. 3 | 2011 180 system has been strictly followed by the adoption of floating exchange rate system in major industrial economies and the other emerging countries over time. Since then, the issue of exchange rate fluctuations has given its impacts on price and aggregate output varying by degree of openness and/or price elasticity of demand. Economists have developed several explanations for the prominent factors of exchange rate fluctuations which have hindered the potential positive outcomes of efficient macroeconomic management strategies as one of the major determinants of aggregate demand and supply. Empirical studies accounting for the reasons of these fluctuations have generally been concentrated on two main approaches. first one suggests that real exchange rate fluctuations result from nominal shocks referring the variation in relative prices of traded goods across countries (Dornbusch, 1976; Krugman, 1990, 1993; Engel, 1993; Eichenbaum & Evans, 1993; Bayoumi & Eichengreen, 1994; Engel, 1999; Roger, 1999). In this vein, Clarida and Gali (1994) obtained similar results, exposing that monetary policy authority affects the real exchange rate by changing price level and nominal exchange rate via its policy instruments. The second insight from empirical researches emphasizes that real shocks, namely productivity-motivated surges, clarify the fluctuations in either real or nominal exchange rates (Balassa, 1964; Samuelson, 1964; Lastrapes, 1992; Inoue & hamori, 2009). The potential causes of exchange rate fluctuations also lead us to examine the theoretical basis of determination of exchange rates since fluctuations partly reflect deviations from the ground on which exchange rates are determined. One of the theories explaining the determination of real exchange rates is purchasing power parity (PPP) theory based on the presumption that a commodity should be sold at same price in various countries excluding transaction costs when measured in a common currency. In other words, a connection is assumed to be prevailing between exchange rate and price indexes of various countries. Exchange rates and changes in exchange rates are accepted as more volatile than relative price levels which accounts for the deviations from PPP as leading factor behind exchange rate movements (Stockman, 1980). Studies analyzing exchange rate fluctuations, have also concentrated on this issue revealing several empirical explanations. As one of leading considerations explaining deviations from PPP condition is the Balassa-Samuelson effect. According to this effect, commodity prices are influenced by relative production costs which are determined by relative productiveness in the sectors producing traded and non-traded commodities. The impact of the tradable sector on the real exchange rate reveals that an increase in the productivity and competitiveness of the tradable sector with respect to foreign countries puts a downward pressure on the real exchange rates (Ricci & MacDonald, 2005). Thus, production process is likely to have a major role in exchange rate fluctuations. The other insight which accounts for deviations from PPP is the monetary approach developed by Mussa (1976), frenkel (1976) and Bilson (1978, 1979) stating that while prices are sticky in the short run, the exchange rate returns to its equilibrium value and PPP holds as prices adjust in the long run. Diebold and Nason (1990) and Meese and Rose (1991) expressed the source of real exchange rate misalignment, suggesting that changes in nominal exchange rates are due to unobservable fundamentals or to non-fundamental factors such as speculative bubbles especially O. OZCELEBI, N. YILDIRIM | REVISITING ThE RELATIONShIP BETWEEN EXChANGE RATES . 181 in short-run related to capital movements. In an effort to argue the consistency of PPP in the long run, huizinga (1987), huang (1990) and Abuaf and Jorion (1990) revealed that cumulative deviations from relative PPP tend to correct themselves in the long run. On the other hand, Roll (1979) and Adler and Lehman (1983) argued that deviations from relative PPP accumulated randomly over time and in turn in the long run relative PPP might also fail. There can be found some other controversial theoretical and empirical arguments attending to major sources of deviations from PPP theory. however it is a stylized fact that rising economic and financial integration processes have stimulated the influence of changes in exchange rates on nominal and real macro economic variables. The widespread perception in open macroeconomics, namely Mundell-fleming modeling, is that upward movement in the exchange rates, depreciation of domestic currency against foreign currency, increases the competitiveness of the country reducing domestically produced goods relative to foreign produced ones and stimulates exports and output growth (Dornbusch, 1976, 1989; Mendoza, 1991). Given the Marshall-Lerner condition is to hold, currency depreciation can stimulate aggregate demand thereby output level. however, expansionary effects of currency depreciation have been challenged by some other theoretical and empirical considerations suggesting that more expensive imported inputs associated with developing countries put a contractionary pressure on output growth increasing the cost of production and hereby inflation (hirschman, 1949; Krugman, 1999; Goldfajn & Werlang, 2000). Another channel of currency depreciation to have reducing effect on income level is that income distribution diverges from wages to profits (Krugman & Taylor, 1978). As expected, currency appreciation has contractionary effects on output growth. At this point, effects of exchange rate volatility on the level of international trade should be considered since total production is influenced by the changes in foreign trade volume. In the literature, some studies such as Clark (1973), Baron (1976), hooper & Kohlhagen (1978) and Broll (1994) reveal that higher exchange risk lowers the expected revenue from exports and therefore reduces the incentives to trade and naturally decreases domestic production. On the other hand, there also exist studies that fail to find a strong negative relation between exchange rate volatility and the volume of international trade. By using Vector Autoregressive (VAR) models, Koray and Lastrapes (1989) and Lastrapes and Koray (1990) expose that exchange rate volatility explains only a small part of the level of imports and exports. Similarly, with instrumental variables approach, frankel and Wei (1993) argue that the effect of exchange rate volatility on trade is ignorable. In another empirical approach, Kandil and Mirzaie (2003) decompose the effects of changes in exchange rates into anticipated and unanticipated parts in a rational expectations framework for 33 developing countries pointing out that unanticipated currency fluctuations have an effect on aggregate demand mainly through exports and imports while anticipated changes in exchange rates have limited effect on output growth. When analyzing the relationship between exchange rates and output, econometric models such as Structural Vector Autoregression (SVAR) and Structural Vector Error Correction (SVEC) allow for theoretical considerations to be incorporated into the esECONOMIC AND BUSINESS REVIEW | VOL. 13 | No. 3 | 2011 182 timation process. This study which investigates the relationship between differences in output levels and exchange rate fluctuations for both Turkey and Germany and Turkey and Russia in two separate models diverges from the previous ones in that we impose long-run restrictions attributable to economic theory within the methodology of SVAR Blanchard-Quah model pioneered by Blanchard-Quah (1989). Within this context, the aim of our study is to reveal the effects of variations in nominal exchange rate on output difference, bilateral real exchange rate and nominal exchange rate in future periods via impulse response functions (IRfs) and forecast Error Variance Decomposition (fEVD) analysis based on the two SVAR Blanchard-Quah models. In a plausible accordance with this aim, two SVAR Blanchard-Qu