Rationality of inflation expectations in a financially repressed economy

Abstract

This study attempts to assess the quality of p u b l i c ’s expectations of inflation by investigating the dynamic interactions between money, prices, income and interest rates in Turkey. Four alternative hypotheses on public expectation formation rule are proposed and tested in the context of the same real money balances model. The fact that interest rates were not determined by the market forces in the investigated period provides sufficient volatility in the real interest rates, and hence reduces the confidence bands of the estimates of the interest sensitivity parameter of the real money demand function. The estimation of parameters and tests of hypotheses are carried out on restricted and unrestricted vector-autoregressive representations of the time series of four economic variables, namely growth rates of money, prices, output and interest rates. Out of sample forecasts are also carried out and compared. Most of the results are in favor of the adaptive and less informed expectations hypothesis rather than rational or more informed ones