Implications of global financial crisis on inflation targetting framework

Abstract

Aside from its devastating effects on global economy, global financial crisis has also shaken the mainstream economic theory. After the crisis, policies implemented by governments and Central Banks, issues of financial stability, impacts of international capital flows and exchange rates have become the center of macroeconomic research. This thesis examines the impact of global financial crisis on the IT framework. The aim is to discuss the imperfections and defections in the framework and propose extensions. In this context, a small open economy DSGE model, calibrated for Turkey during 2003- 2012 is proposed. The base model is extended to capture dynamics of Turkish economy better. Since, trade and credit channels of transmission mechanism of crisis are the most powerful channels for the contagion of the crisis to Turkish economy, inclusion of net international investment position (to the problems of households and entrepreneurs) and imported capital good (to the production function) strengthen the explanatory power of the model considerably. Moreover, to address whether allowing Central Bank to respond exchange rates yields gains in terms of output and inflation stabilization, an augmented Taylor rule which incorporates exchange rates is constructed. Responses under the benchmark model where Central Bank uses a traditional Taylor rule and an augmented Taylor rule are obtained. To provide a reference in interpreting the findings of the model, a Vector Auto Regression analysis is performed with interest rates, inflation, output level and exchange rates as endogenous variables. Finally, results of the model experiments and VAR are compared. The results indicate that, the model with the augmented Taylor rule can help to smooth business cycle fluctuations more effectively than conventional Taylor rule but, in some cases, Central Bank may encounter with a tradeoff between output gap and inflation.