How bad can inflation be? Lessons from Turkey

By: Arshia Singha | Lady Brabourne College

Turkey is an emerging market. It has seen two decades of broad economic growth and an expanding middle class. It has traditionally been considered one of the most open and advanced Muslim democracies.

But today, Turkey is in economic turmoil. People are queuing up for bread, cutting back on meat, and some are even fleeing the country. Turkey’s annual inflation rate jumped more than 36% in the month of December 2021 (CNBC, 2022). The value of the Turkish lira has slumped to a record low, forcing retailers to hike prices sharply. The currency has suffered as a result of several central bank rate cuts, forced through by President Recep Tayyip Erdoan. His severe economic mismanagement is threatening to unravel all the progress that has been made in the past two decades.

Traditional methods of controlling inflation

When an economy expands as a result of greater spending but not as a result of increased production of goods and services, this is referred to as inflation. As interest rates fall, more people will be able to borrow money. As a result, customers have greater disposable income. This causes the economy to grow and inflation to increase. Prices rise as a result, and the economy’s currency is worth less than it was previously. The currency will not be able to purchase as much as previously. Turkey’s current crisis has been caused by Mr. Erdoan’s insistence on lowering interest rates in the face of galloping inflation—exactly the opposite tactic to that which economists almost universally prescribed.

Traditionally, monetary policies are implemented by central banks to combat inflation. Monetary policy is an economic policy that controls the quantity and pace of expansion of an economy’s money supply. It’s an effective strategy for controlling macroeconomic factors like inflation and unemployment. These policies are achieved via a variety of mechanisms, including interest rate adjustments, the purchase or sale of government securities, and changes in the amount of currency in circulation.

To control high inflation, the interest rate has been increased. When the interest rate rises, the cost of borrowing also rises. This makes borrowing expensive. Hence, borrowing will decline, and as such, the money supply (the amount of money in circulation) will fall. A fall in the money supply will lead to people having less money to spend on goods and services. As a result, they will purchase fewer goods and services. This, in turn, will lead to a fall in the demand for goods and services. With the supply remaining constant and the demand for goods and services declining, the price of goods and services will fall.

Then why doesn’t the Turkish government increase interest rates?

Turkish leader Erdoan is a strong believer in Islamic finance, which suggests that interest is bad.

Erdoan‘s policies are a misguided attempt to stay in power rather than based on sound economic theory. He has justified his policies by quoting verses from the Quran and claiming it is his duty as a Muslim to adhere to Islamic jurisprudence (Statecraft, 2022). Erdoan provided two reasons for lowering interest rates (The Washington Post, 2021).

• High-interest rates slow economic growth.
• High-interest rates help to curb inflation.

The first argument holds true. Banks are less able to borrow to maintain mandatory reserves when a central bank raises rates, so they tend to lend at their own higher rates. This makes corporate loans more difficult to come by and more expensive, thus slowing the economy. Erdoan believes that if the lira loses value against the dollar, Turkey’s exports will simply become cheaper and foreign consumers will want to buy even more. This would increase the competitiveness of smaller manufacturing companies and also shift spending from imports to domestic goods and services. But his second argument contradicts conventional economic theories. Higher interest rates result in lower borrowing and help curb inflation.

Conclusion

Erdoan’s notions are deeply flawed. His unorthodox views have rattled the Turkish markets. The rate cuts have raised concerns over the bank’s independence, while the country’s unconventional monetary policy has spooked foreign investors, who are dumping Turkish assets (The Indian Express, 2021).

Turkey heavily relies on imports for food, fuel, and fertilizer. The currency devaluation means that small businesses and farms are not able to afford to import goods that they need to keep their business going. The irony is that wealthy institutions have access to financial instruments like futures to mitigate their exposure to currency fluctuations. Wealthy Turks with savings have also moved their cash into American dollars or euros, further accelerating the decline of the Lira. Therefore, it is the working class and small businesses that are burdened with the pain of this recent crisis.