metadata: authors: 0: author: Everaert,Luc
count: Türkiye
docna: 0: docna: Inflation stabilization in Turkey : an
            application of the RMSM-X model
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Theory & Research,Economic Adjustment and Lending,Industrial Economics,Public Sector Economics,Economic Growth,Inflation,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction
teratopic: Finance and Financial Sector Development
abstracts: cdata!: This paper reviews the theoretical
            framework of an inflation stabilization program. In the
            absence of price rigidities, a reduction in inflation simply
            implies finding a replacement for revenue lost from a
            decline in the inflation rate. In reality, backward-looking
            nominal contracts and credibility problems induce short-run
            costs, making a fall in the economic growth rate an
            inevitable part of inflation stabilization. The theoretical
            framework yields the specification of a few key behavioral
            equations to be implemented in the model. The author's
            simulation results show that even if a credible program is
            implemented, at least two years of negative per capita
            growth are needed to bring inflation down from its current
            levels to below 10 percent a year. The accompanying fiscal
            effort is great: the equivalent of a 40 percent increase in
            direct tax revenues if no other expenditure or revenue
            measures are taken. Scenarios that do not incorporate strong
            fiscal action do not succeed in permanently lowering
            inflation and lead to lower per capita GDP at the end of the
            decade than does the scenario of fiscal stabilization.
            Inflation in the Turkish context is costly because it
            reduces not only the level of productive investment but also
            its efficiency.
geo_reg_key: 517208,517198,517190,119229,517191
repnme: repnme: Inflation stabilization in Turkey : an
            application of the RMSM-X model
display_title: Inflation stabilization in Turkey :
            an application of the RMSM-X model
listing_relative_url: /research/1992/01/699805/inflation-stabilization-turkey-application-rmsm-x-model
topicv3: Economic Growth m1326241 471,Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Fiscal Policy m1327144 445,Monetary Policy m1327609 444
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Europe and Central Asia: Country Department I
no_of_pages: 56
author_keys: 0: author_key: 769096
model_extractions: <!-- Start of picture text --> Policy Research_<br>Country Operations|<br>WPS 845<br><!-- End of picture text -->

This papera product of the Country Operations Division, Country Deparu.meit 1, Europe and Central Asia Region-,spartofa largereffort in the Region to enhance itsmacroeconomic monitoring capabilities. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Barbara Mondestin, room H5-105, extension 36071 (51 pages). January 1992.

The model Everaert persents is an extension of the simple RMSM-X model developed to improve the Country Operations Division's macroeconomic monitoring and modeling capabilities. Adding econometrically estimated behavioral equations and the use of lagged relationships makes the model fit for short-run simulations while maintaining an essentially recursive structure and thus keeping computational costs at a minimum.

First, Everaert reviews the theoretic-: framework of an inflation stabilization program. In the absence of price rigidities, a reduction in inflation simply implies finding a replacement for revenue lost from a decline in the inflation rate. In reality, backward-looking nominal contracts and credibility problems induce shortrun costs, making a fall in the economic growth rate an inevitable part of inflation stabilization. The theoretical framework yields the specification of a few key behavioral equations to be implemented in the model.

Next, Everacrt shows in detail how this theoretical framework is implemented in the RMSM-X model by specifying demand and supply sides of all markets. An econometrically estimated short-run price equation plays a key role.

Everacrti's simulation results show that even if a credible program is implemented, at least two years of negative per capita growth are needed to bring inflation down from its current levels to below 10 percent a year. The accompanying fiscal effort is great: the equivalent of a 40 percent increase in direct tax revenues if no other expenditure or revenue measures are taken. Scenarios that do not incorporate strong fiscal action do not succeed in permanently lowering inflation and Icad to lower per capita GDP at the end of the decade than does the scenario of fiscal stabilization. Inflation in the Turkish context is costly because it reduces not only the level of productive investment but also its efficiency.

The Policy Research Working Paper Seriesdisseminates thc findings of work under way in the Bank. An objective ofthe series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
# TABLE OF CONTENTS

# Inflation Stabilization in Turkey: An Application of the RMSM-X Model

# by Luc Everaert

1. The Structure of the Model 1 1.1. The Budget Constraints 2 1.2. The Markets 5 1.3. Model Closure and Solution Procedure 6

2. Inflation Stabilization: Theoretical Framework 9 2.1. Inflation and Fiscal Deficits In a Mundell-Fleming Model 9 2.2. Disinflation in the Medium-Run 12 2.3. Short-Run Price Inertia and the Costs of Disinflation 13 3. Implementation in the RMSM-X Model 15 3.1. The Goods Market 16 3.2. The Money Market 19 3.3. The Foreign Credit Market 22 3.4. Central Bank Credi 24 3.5. The Domestic Bond Market 25 3.6. Projecting Other Variables 25 4. Inflation Stabilization in Turkey 27 4.1. Recent Economic Developments 27 4.2. Costs of Inflation 30 4.3. Fiscal Adjustment for Sustainable Disinflation 32 4.4. Monetary Contraction without Fiscal Adjustment 43 5. Concluding Remarks 48 References 50 I am particularly indebted to Michael Lewin, Jaume Ventura, Paulo Vieira da Cunha and Steve Webb for their assistance and helpful discussion and to Rudi Dornbush, William McCleary and Roberto Rocha for their valuable comments.
The World Bank has recently upgraded its<sup>&lQvisedMinimum Standard Model, from an</sup> set of projection rules for the balance of payments<sup>and the national accounts, to a RMSM-X</sup> (eXtended), which attempts to model the Interaction<sup>of the different sectors of an economy in a</sup> consistent manner. This macro-model is mainly<sup>used for medium-term projections required to</sup> guide the Bank's operational decisions. The model<sup>focuses on .he budget constraints of the</sup> different sectors, especially on the fiscal accounts<sup>and the foreign sector (the balance of</sup> payments) as they are key determinants of the macroeconomic<sup>balances. The RMSM-X model</sup> contains few estimated relations s.rice for most<sup>countries good time series data is unavailable</sup> and frequent shifts In policy-regimes make most<sup>estimated parameters unstable.</sup> The purpose of .; ,s paper is to show how, by<sup>making creative use of lagged economic</sup> relMtionships and adaptive price setting mechanisms (ie. backward<sup>looking contracts), the RMSM-</sup> X model can be used for short-term policy si,nulations.<sup>In particular, attention is paid to the</sup> short-run output costs of inflation stabilization as a result of price<sup>rigidities. The recursive solution</sup> of the model, leading to quantity closures of different markets<sup>does lower the confidence one can</sup> have in the point forecasts of the simulation. By<sup>testing the sensitivity of the simulations to the</sup> chosen path of the key intermediate variable (in this case<sup>the domesiic real Interest rate), and</sup> by checking whether the solution enters in the confidence interval<sup>of existing econometrically</sup> estimated equations, not incorporated in the model, this<sup>confidence can be greatly enhanced.</sup> This paper first reviews the main features of the basic<sup>RMSM-X model ancd then applies</sup> the model to the problem of inflation stabilization in<sup>the Turkish context. The second section of</sup> the paper establishes the theoretical framework for<sup>the analysis of the problem of disinflation.</sup> The third section shows how the RMSM-X model can be<sup>adapted for short-run policy simulations</sup> by incorporating some additional estimated behavioral equations.<sup>The fourthi section the paper</sup> reviews briefly the relevant recent economic developments in<sup>Turkey and then presents a</sup> scenario of adequate fiscal adjustment that leads to a sustainable<sup>reduction of inflation. This</sup> scenario is compared with a policy of monetary contraction<sup>without fiscal support. In both</sup> scenarios attention is paid to price rigidities which lead to short-run<sup>adjustment costs in terms</sup> of oLtput lost. A final section summarizes the main findings.

# 1. **THE** STRUCTURE OF THE MODEL

The RMSM-X model starts conceptually from a flow-of-funds<sup>matrix which contains the</sup> budget constraints of all the specified sectors in tne economy.<sup>in this way, no matter how the</sup> variables entering the budget constraints are projected, consistency<sup>is assured. In order to</sup>
2 introduce meaningful economic behavior in the model, markets need to be added to the budget constraints and domand and supply behavior needs to be specified. Since only a limited set of variables can be solved for endogenously, the specification of this set determines the nawre of the closure of the model.

## 1.1. THE BUDGET CONSTRAINTS

The model assures consistency In the projections by requiring that the budget constraints for the economic sectors are satisfied at all times. Six different sectors are identified in the Turkey model: (i) the non-financial State Economic Enterprises, (ii) the rest of the non-financial public sector, which is called nbudget", (iii) the private non-financial sector, (iv) the central bank, (v) the domestic banking system, and (vi) the foreign sector. The symbols used In the budget constraints throughout the paper are explained In Table 1.1.1Y Figure 1.1 presents the budget constraints of the six sectors in flow-of-funds '-rmat, omitting the time subscript for current endof-period stocks and for flows occurring during the current period to save notationY Each budget constraint consists of two statements of the type:

# CURRENT INCOME - CURRENT EXPENDITURE = SAVING

## SAVING = NET ACCUMULATION OF WEALTH

The top half of Figure 1.1 presents the current account of all sectors in matrix format while the bottom half shows the capital account. All budget constraints are defined in nominal terms and include sufficc Jetail in order to distinguish the most relevant categories of income, expenditure an w.hanges in assets for each of the sectors. In both matrices, rows represent incoming and columns outgoings. The specification of the various entries in the matrices is

## Throughout the paper we will use the following conventions:

**A** SX - x-x.,; x- S6/.,

## A superscript asterisk indicates a foreign currency denominated variable.

_v_ For a more detailed description of the budget constraints and the flow-of-funds concept see Everaert et. al. (1990).
3

# TABLE **t.1: DEFINmOI3 OF VARIABLES IN BUDGET CONSTRAINTS**

Variables with an asterisk are defined<sup>in US$. The rest of the variables are expressed in</sup> local currency at current prices<sup>except for those variables marked with (#) which are deflned in</sup> constant terms.

|B|Bonds|
|---|---|
|C<br>|Consumption (#)<br>|
|CR<br>|Credit from the Central Bank<br>|
|CU<br>|Currency in circulation<br>|
|DD<br>|Demand deposits<br>|
|E<br>|Average exchange rate<br>|
|F<br>|Net foreign-currency denominated<sup>borrowing</sup><br>|
|FG<br>|External debt<br>|
|FX<br>|Foreign currency deposits with domestic<sup>sectors</sup><br>|
|Fl<br>|Factor income<br>|
|I<br>|Investment (#)<br>|
|i,|Nominal foreign Interest rate<br>|
|iD<br>|Nominal interest rate on deposits<br>|
|ic|Nominal interest rate on credits<br>|
|jR<br>|Nominal rate of rediscount<br>|
|IM<br>|Imports (#)<br>|
|KT<br>|Capital transfers<br>|
|NW<br>|Net worth<br>|
|OFI<br>|Other factor income<br>|
|P&L<br>|Distributed profits<br>|
|PR'<br>|Profit remittances abroad<br>|
|R<br>|Foreign reserves<br>|
|RR|Legal reserves<br>|
|S<br>|Savings<br>|
|SUB<br>|Subsidies<br>|
|T|Net current transfers<br>|
|T'|Net transfers from abroad|
|TD|Direct taxes|
|TI|Indirect taxes|
|VA<br>|Value added<br>|
|WR<br>|Workers, remittances from abroad<br>|
|X|Exports (#)|

Sector-specific variables and intersectoral<sup>flows are represented by the following suffixes at the</sup> end of each variable:

- b Budgetary government

- c Central Bank

- d Banking system

- Other non-financial public sector (SEEs)

- g Consolidated non-financial public sector p Private sector

- m Consolidated monetary sector f Foreign sector t Total
4

# FIGURE 1.1: SOURCES AND USES OF FUNDS MATRIX

## CURENT MCOlIM

||Covernrnt<br>Buidget|Other<br>Public|Private<br> <br>Sector|Central<br>Bank|Banktf<br>Sylte|oBalance of<br>Production<br>Payments<br>Account|<br>Total<br>Sources|
|---|---|---|---|---|---|---|---|
|Govariuent<br>gudet||_~~~<br>TDo|~~~~~~~~~~<br>TDp|~~~~~~~~~<br>P&L.|~~~~~~~~~~<br>||<br>I<br>EeTf;<br>|-SUB<br>_<br>Ib|||
|Other<br>Pubh ic__|Tbo|_<br>_<br>_<br>_<br>|<br>_<br>_<br>_<br>_<br>_<br>|_||Fi0||<br>I|
|**Private**<br>Sector|Tb<br>fcq p|_<br>_|I<br>_||P|E_Tf_ p<br>**VAp**<br><br>IdEW RE|||
|Central<br>BMWrig|**fR'CRb**<br>**fObd**|fiRC3<br>.1<br>fCd<br>|| _<br>_<br>I<br>C dl|<br>|,R<br>d<br>I|i(Rf-FdI|<br>I<br>I|I<br>|
|Batance of<br>**Payits**|E-f*f**Fb**|1<br>E-i *fO||I<br>Ef-***F;**I<br>IE*PR|Eoi *Fc<br>i|**Edid***fd|-<br>1<br> <br>-I<br>,|I<br>||
|ConLoptf<br>_wxf Savngs_|anC4<br>_Sb_|S.|**cp**<br>_SP_|M.<br>||°<br>|<br>d|,<br>°||
|Totat||||||||
||Gaverrnent<br>Uui et|other<br>Pubtic|Private<br>Sector|CAPITA<br>Central<br>Bank|L ACCOUT<br>Bafkino<br>Sstem|Balance of<br>Savirns<br>Payments<br>Account|Total<br>Sources|
|Governent<br>BudgetI||_____|bp<br>1||ICRb<br>I||8<br>I||E8F'b<br>|<br>I<br>II|Sb<br>||
|Other<br>PUbtic|KTb0||a'Be <br>II<br>|~<br>I5CR.<br>I|<br>|.<br><br>IEFBO<br>IESO<br>I<br>I.<br>I<br>|I<br>I||
|Private<br>Sector|KTbp|KTp<br>.I|||13<br>6I<br>|Td||E.SF*<br>ISp<br>IE-6I||
|Centrat<br>**Bnk***|_|CUd|6oUp||Mo|E-6F;<br>|<br>_U_<br>W<br>I<br>I<br>I<br>|I<br> <br>I|
|Banking<br>System|KTbd||oD||6CRd|||ESFd<br>|<br>d||
|B*lInoe<br>of<br>**Pay**<br>**ts___**|||lf<br>.|E-M'.<br>| E||||
|Investoent<br>Account|<br>lb|1o<br> <br>_<br>_<br>_<br>_<br>_|I<br>p<br>_<br>_<br>_<br>_<br>__|||_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>|_<br>_<br>_<br>_|
|Total<br>Uses|=I||||I|I<br>|I<br>I|