Inflation stabilization in Turkey : an application of the RMSM-X model

Policy Research WORKING PAPERS Country Operations Country Department I Europe and Central Asia Region The World Bank January 1992 WPS 845 Inflation Stabilization in Turkey An Application of the RMSM-X Model Luc Everaert Adding estimated behavioral equations to the standard RMSM- X model allows it to simulate the short-run consequences of inflation stabilization. Policy Rescarch Wodring Papers disseminatc the findings of work in progress and cncouragc the exchange of ideas among Bank staffand allothers interested in developnientiss is. Thesepapcrs. distuibuted by the Research Advisory Staff.carry the names of theauthors, reflect only theirviews, andshouldbeused and cited accordingly. The findings, inerprctaLions,and conclusions are theauthors'own. Theyshould not be attributed to the World Bank, its Board of Directors, its managemcnt, or any of its member countries.  Policy Research_ Country Operations| WPS 845 This paper- a 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 Next, Everacrt shows in detail how this the simple RMSM-X model developed to theoretical framework is implemented in the improve the Country Operations Division's RMSM-X model by specifying demand and macroeconomic monitoring and modeling supply sides of all markets. An econometrically capabilities. Adding econometrically estimated estimated short-run price equation plays a key behavioral equations and the use of lagged role. relationships makes the model fit for short-run simulations while maintaining an essentially Everacrti's simulation results show that even recursive structure and thus keeping computa- if a credible program is implemented, at least tional costs at a minimum. two years of negative per capita growth are needed to bring inflation down from its current First, Everaert reviews the theoretic-: levels to below 10 percent a year. The accompa- framework of an inflation stabilization program. nying fiscal effort is great: the equivalent of a 40 In the absence of price rigidities, a reduction in percent increase in direct tax revenues if no other inflation simply implies finding a replacement expenditure or revenue measures are taken. for revenue lost from a decline in the inflation Scenarios that do not incorporate strong fiscal rate. In reality, backward-looking nominal action do not succeed in permanently lowering contracts and credibility problems induce short- inflation and Icad to lower per capita GDP at the run costs, making a fall in the economic growth end of the decade than does the scenario of fiscal rate an inevitable part of inflation stabilization. stabilization. Inflation in the Turkish context is The theoretical framework yields the specifica- costly because it reduces not only the level of tion of a few key behavioral equations to be productive investment but also its efficiency. implemented in the model. 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 &lQvised Minimum Standard Model, from an set of projection rules for the balance of payments and the national accounts, to a RMSM-X (eXtended), which attempts to model the Interaction of the different sectors of an economy in a consistent manner. This macro-model is mainly used for medium-term projections required to guide the Bank's operational decisions. The model focuses on .he budget constraints of the different sectors, especially on the fiscal accounts and the foreign sector (the balance of payments) as they are key determinants of the macroeconomic balances. The RMSM-X model contains few estimated relations s.rice for most countries good time series data is unavailable and frequent shifts In policy-regimes make most estimated parameters unstable. The purpose of .; ,s paper is to show how, by making creative use of lagged economic relMtionships and adaptive price setting mechanisms (ie. backward looking contracts), the RMSM- X model can be used for short-term policy si,nulations. In particular, attention is paid to the short-run output costs of inflation stabilization as a result of price rigidities. The recursive solution of the model, leading to quantity closures of different markets does lower the confidence one can have in the point forecasts of the simulation. By testing the sensitivity of the simulations to the chosen path of the key intermediate variable (in this case the domesiic real Interest rate), and by checking whether the solution enters in the confidence interval of existing econometrically estimated equations, not incorporated in the model, this confidence can be greatly enhanced. This paper first reviews the main features of the basic RMSM-X model ancd then applies the model to the problem of inflation stabilization in the Turkish context. The second section of the paper establishes the theoretical framework for the analysis of the problem of disinflation. The third section shows how the RMSM-X model can be adapted for short-run policy simulations by incorporating some additional estimated behavioral equations. The fourthi section the paper reviews briefly the relevant recent economic developments in Turkey and then presents a scenario of adequate fiscal adjustment that leads to a sustainable reduction of inflation. This scenario is compared with a policy of monetary contraction without fiscal support. In both scenarios attention is paid to price rigidities which lead to short-run adjustment costs in terms 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 matrix which contains the budget constraints of all the specified sectors in tne economy. in this way, no matter how the variables entering the budget constraints are projected, consistency is assured. In order to  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 end- of-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 in US$. The rest of the variables are expressed in local currency at current prices except for those variables marked with (#) which are deflned in constant terms. B Bonds C Consumption (#) CR Credit from the Central Bank CU Currency in circulation DD Demand deposits E Average exchange rate F Net foreign-currency denominated borrowing FG External debt FX Foreign currency deposits with domestic sectors Fl Factor income I Investment (#) i, Nominal foreign Interest rate iD Nominal interest rate on deposits ic Nominal interest rate on credits jR Nominal rate of rediscount IM Imports (#) KT Capital transfers NW Net worth OFI Other factor income P&L Distributed profits PR' Profit remittances abroad R Foreign reserves RR Legal reserves S Savings SUB Subsidies T Net current transfers T' Net transfers from abroad TD Direct taxes TI Indirect taxes VA Value added WR Workers, remittances from abroad X Exports (#) Sector-specific variables and intersectoral flows are represented by the following suffixes at the end of each variable: b Budgetary government c Central Bank d Banking system o 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 Other Private Central Banktfo Balance of Production Total Buidget Public Sector Bank Sylte Payments Account Sources _~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ I Govariuent TDo TDp P&L. | EeTf; |-SUB gudet _ Ib | Other Tbo _ Fi0 | Pubh ic__ _ _ _ _ _ _ _ _ _ I Private Tb _ _I _ E_Tf_ p VAp | Sector fcq p P Id EW RE Central fR'CRb fiR C3 | _ _ ,R d .1 i (Rf-FdI | I BMWrig fObd fCd I C dl I I I Batance of 1 I - 1 I Payits E-f*f Fb E-i *fO| Ef- *F; I Eoi *Fc Edid *fd -I , | IE*PR i Con Loptfan C4 cp M.