Download An open economy new Keynesian macroeconomic model: The case

İktisat İşletme ve Finans 26 (305) 2011 : 37-56
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doi: 10.3848/iif.2011.305.2978
l
An open economy new Keynesian macroeconomic
model: The case of Turkey†
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Abstract . A new consensus in macroeconomics called the New Neo-Classical Synthesis or New
Keynesian Macroeconomic Model emerged at the end of the 1990s. The main characteristics
of this consensus are formed by the synthesis of the New Classical, Real Business Cycle and
New Keynesian approaches. Although The New Keynesian Macroeconomic Model is based on
a general equilibrium model, it can typically be reduced to a three-equation system, consisting
of an aggregate supply equation (Phillips curve), an aggregate demand equation (IS equation)
and a monetary policy rule. The basic model assumes a closed economy. However, for a small
open economy, such as Turkey, whose growth is largely affected by international capital
flows, the ability of the standard New Neo-Classical Synthesis model to fully take into account
economic dynamics is limited. In this paper, we attempt to extend the New Neo-Classical
Synthesis model to a small open economy case by adding equations that would capture the
exchange rate movements and the current account dynamics. Results indicate that the open
economy New Neo-Classical Synthesis model for Turkey can provide a framework to capture
the dynamics of the Turkish economy for the post financial liberalization era and explain the
behavior of the Central Bank of the Republic of Turkey.
Keywords: Open economy, New neo-classical synthesis, Monetary policy
JEL Classification: F41, E52, C32
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Özet. Açık ekonomi yeni Keynesyen bir makroekonomik model: Türkiye uygulaması
Makro iktisatta 1990’ların sonunda Yeni Neo-Klasik Sentez ya da Yeni Keynesyen
Makroekonomik Model olarak adlandırılan yeni uzlaşı oluşmuştur. Bu uzlaşının temel özelliği
Yeni Klasik, Reel İş Çevrimleri ve Yeni Keynesyen yaklaşımların sentezinden meydana gelmiş
olmasıdır. Yeni Keynesyen Makroekonomik Model bir genel denge modeline dayanmakla
beraber, toplam arz denklemi (Phillips Eğrisi), toplam talep denklemi (IS denklemi) ve bir
para politikası kuralından oluşan üç denklemli bir sistem olarak da ifade edilebilmektedir.
Temel model kapalı bir ekonomi varsaymaktadır. Bununla birlikte, Türkiye gibi büyümesi
uluslararası sermaye hareketlerine bağlı küçük açık ekonomiler için, standart Yeni NeoKlasik Sentez modelinin ekonomik dinamikleri açıklama yeteneği sınırlıdır. Bu çalışmada,
standart bir Yeni Neo-Klasik Sentez modeli döviz kuru hareketlerini ve cari açık dinamiklerini
dikkate alan denklemler eklenerek küçük bir açık ekonomi için genişletilmiştir. Elde edilen
sonuçlar açık ekonomi Yeni Neo-Klasik Sentez modelinin finansal serbestleştirme sonrası
Türkiye ekonomisinin dinamiklerini ve Türkiye Cumhuriyet Merkez Bankasının davranışlarını
açıklamak için bir çerçeve olarak kullanılabileceğini göstermektedir.
Anahtar Kelimeler: Açık ekonomi, Yeni neo-klasik sentez, Para politikası
JEL Sınıflaması: F41, E52, C32
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† Earlier versions of this paper were presented at the 9th International Conference of the Middle East Economic Association, Istanbul Technical University, Maçka-Istanbul, June 24-26,
2010, and the 2nd International Conference on Economics, Turkish Economic Association,
Girne-Turkish Republic of Northern Cyprus, September 1-3, 2010. We are grateful to both
conference participants and an anonymous referee for helpful comments. Special thanks to Pier
Roberts for proofreading the entire manuscript and helping to season it.
*
Çukurova University, Department of Economics, [email protected]
**
Çukurova University, Department of Econometrics, [email protected]
***
Çukurova University, Department of Economics, [email protected]
2011© Her hakkı saklıdır. All rights reserved.
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Received 01 November, 2010, received in revised form 15 February 2011;
Accepted 21 March, 2011
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Erhan Yıldırım*, Kenan Lopcu**, Selim Çakmaklı***
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1-Introduction
A new consensus in macroeconomics called the New Neo-Classical
Synthesis (NNS) or New Keynesian Macroeconomic Model (NKMM)
emerged at the end of the 1990s. The main characteristics of this consensus
are formed by the synthesis of the New Classical, Real Business Cycle and
New Keynesian approaches. The new consensus models offer a combination
of various elements, such as intertemporal optimization, rational expectations,
imperfect competition and staggered price adjustment. These elements are
brought together under a dynamic stochastic general equilibrium (DSGE)
framework. Typically DSGE models are represented in three-equation
systems, consisting of an aggregate supply equation (Phillips curve), an
aggregate demand equation (IS equation) and a monetary policy rule.
The new consensus provides a new framework for implementations of
economic policies and outcomes. In particular, in terms of economic stability,
it emphasizes the role of monetary policy in the short run. Monetary policy is
implemented by central banks, using the short-run interest rate as a monetary
policy instrument in order to ensure price stability.
The NNS model has generally been analyzed in a closed economy context.
However, for a small open economy, such as Turkey, whose growth is largely
affected by international capital flows, the standard NNS model’s ability to
fully account for economic dynamics is limited. In this paper we estimate an
extended version of the NNS model for Turkey. Our model is largely based
on Arestis (2007) and Buncic and Melecky (2008).
As shown in Figure 1, the current account deficit (as a percent of GDP)
and the GDP gap have similar dynamics in Turkey. One of the principal
rationales for our estimating the open economy version of the NNS model
for Turkey is this similarity of fluctuation in current account and GDP. The
number of studies dealing with an open economy NNS model for Turkey is
extremely limited. Two noteworthy recent studies are Huseynov (2010) and
Ünalmış, Ünalmış and Ünsal (2010) which rely on Bayesian methodologies.
The main purpose here is to estimate the structural parameters of the open
economy NNS model and investigate whether it can be used to explain
observed fluctuations of the Turkish economy, rather than performing a
model calibration. Structural parameters of the model are estimated by the
Full Information Maximum Likelihood (FIML) method. Needless to say the
estimates of structural parameters obtained here can be used for calibration
purposes.
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İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
We prefer to use the term New Neo-Classical Synthesis (NNS) rather than New Keynesian Macroeconomic Model
(NKMM) to avoid confusion with the New Keynesian Economics.
We are thankful to the anonymous referee for bringing this study to our attention.
38
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
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2-Brief History of the New Consensus Macroeconomic Model
As stated in Blanchard (2000, p.1376), the history of macroeconomics
in the 20th century can be analyzed in three different eras. According to this
classification, the period before the 1940s was a period of discovery, and the
theory at that time did not have a unified framework. Macroeconomic issues
then consisted of monetary policy and business cycle theory. After 1940,
macroeconomics was subject to extensive discussion. From the 1940s to
1980, the process of macroeconomic analysis evolved towards an integrated
approach. Beginning with the IS-LM model, the dynamic general equilibrium
model was developed, and the roles of shocks and transmission mechanisms
were clarified. During this period, Neo-Classical Synthesis emerged and
became the dominant theory in macroeconomic policy discussions. The
period from the 1980s to date, on the other hand, can be considered a new era
of discovery and exploration. In this new era, macroeconomic studies have
focused on macroeconomic imperfections, such as the relevance of wage and
price settings, incompleteness of markets, asymmetric information, search and
bargaining in decentralized markets and increasing returns in production.
[Ç
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This study consists of 5 sections, including the introduction. A brief
historical development of the new consensus in macroeconomics is provided
in section 2. Data and methodology are explained in section 3. Results and
discussion are presented in section 4. And finally, some concluding remarks
are offered in section 5.
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1. Current account and GDP gap for Turkey, 1990-2009

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The Neo-Classical Synthesis shaped after the post-war period was based
on two fundamental principles. According to the first principle, the rational
behavior of individuals and companies can be studied using the standard
methods of microeconomics. The second principle holds that market prices
and wages cannot adjust immediately to the full employment equilibrium
level. However, full employment can be achieved with the use of monetary
and fiscal policies (Blanchard, 2008).
The consensus which was built around the Neo-Classical Synthesis in
macroeconomics until the mid-1970s was unraveled because of the empirical
failure of the Phillips curve and the lack of microeconomic principles of
macroeconomic inferences. After the demolition of the Neo-Classical
Synthesis, economic researchers in general divided into two camps: on the
one hand, there was the New Classical Economics and the Real Business
Cycle Theory with rational expectations and continuous market clearing
assumptions; on the other hand, there was the New Keynesian Economics
with its attempt to find micro foundations which are consistent with rational
expectations for the Keynesian wage and price rigidities.
Although the New Keynesian models accept the assumption of rational
expectations, they differ from the New Classical Economics in terms of
price setting. In New Classical Economic models, firms are price takers
in competitive markets, but supply decisions are taken under incomplete
information conditions. In contrast, in the New Keynesian Economics, firms
are price setters in imperfectly competitive markets (monopolistic competition)
(Snowdon, Vane & Wynarczyk, 1995, p.291; Gordon, 1990, p.1136).
New Keynesian models that have been developed since the 1980s take
into account both nominal and real rigidities and have demonstrated that
economic policy can be used to ensure economic stability in the short run.
Although some disagreements continue about various theoretical
points, there is a new consensus in macroeconomics wherein a satisfactory
macroeconomic model should include a rational expectations hypothesis,
wage and price rigidities and optimization behavior of individuals, firms
and policy makers (Carlin & Soskice, 2006, p. 563). The main feature of
this consensus is that it brings together the intertemporal optimization and
rational expectations hypothesis of the New Classical Economics and the
Real Business Cycle Theory, imperfect competition and the costly price
adjustment elements of the New Keynesian Economics (Goodfriend & King,
1997, p.25). The key idea in the new consensus is that the firm’s price setting
behavior causes some temporary nominal rigidities, thus enabling monetary
policy to have real effects in the short run while maintaining the neutrality of
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İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
See Mankiw (1990) for a detailed discussion.
See Gordon (1990) for a comprehensive survey of New Keynesian Economics.
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money in the long run (Clarida, Gali & Gertler, 1999). Nevertheless, the New
Neo-Classical Synthesis differs from the old consensus in terms of its reliance
on dynamic micro foundations and the imperfect competition equilibrium
models (Dixon, 2008, p.3). Another important difference is that the money
supply is endogenous in the new synthesis as opposed to being exogenous in
the old one.
The NNS approach to monetary policy analysis includes the systematic
use of the dynamic stochastic general equilibrium framework. A typical
general equilibrium model can be formulated in the form of three blocks:
aggregate demand, aggregate supply, and a policy rule. Aggregate demand and
aggregate supply are derived from the maximization problem of households
and firms, respectively, and the policy rule is derived from the minimization
of the social loss function. Firms are modeled in the context of monopolistic
competitive markets. Each firm has a well-defined demand curve for the goods
it produces, and it sets prices to maximize its discounted profits. In the model,
the main source of the non-neutrality of monetary policy is nominal rigidities.
Generally, nominal rigidities are introduced in the form of restrictions on the
frequency of the price (wage) setting process of firms (employees). These
limitations on price (wage) decisions imply the forward-looking component
of the price (wage) decision, because each economic agent recognizes that
prices (wages) will remain constant for a certain time. In this case, it will be
optimal to take into account expectations about the future demand and cost
conditions. In this way the new consensus models bring a new perspective to
the nature of inflation dynamics.
One source of observed fluctuations in inflation in the NNS model is
the output gap, which is defined as deviations of the current output level
from its equilibrium level in the absence of nominal rigidities. The central
bank responds to deviations of inflation and output from their equilibrium
levels by adjusting the short run interbank interest rate. The transmission of
monetary shocks to real variables works through a conventional interest rate
channel. Thus, dynamic stochastic general equilibrium models with nominal
rigidities provide a utility based welfare criterion to evaluate the desirability of
alternative monetary policies. This policy rule associated with small welfare
losses (derived from the minimization of welfare loss function) provides a
good approximation to the optimal rule and is not subject to the Lucas critique
(Gali, 2002, pp. 2-3 and Gali, 2009, pp. 1-2).
B
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3-Data and Methodology
As stated above, a typical closed economy version of the NNS model
is represented with a three-equation system, consisting of an aggregate
supply equation, aggregate demand equation and a monetary policy rule.
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İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
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
These equations can be estimated separately or simultaneously as a system.

However,
the closed economy version of the NNS model could be inadequate
for a small open economy, such as Turkey, whose growth is largely affected
 π = δ E t πcapital
( −has


π t − +and
δ  −lasting
δ  )(er
) + λyt +deficit
ε AS,t  problems.
t + + δ flows
t + π t account
by international
current
 t
Yıldırım,
Lopcu, Çakmaklı and Özkan (2010) conclude that the standard


NNSmodel’s ability to fully account for economic dynamics is limited for
Turkey.
 π = δ E π + δ π + ( − δ − δ )(er + π  ) + λy + ε 


 t t +
 t −


t
t
AS,t
We t employ
the following
model
which
ist a modified
version
of Arestis’s
Eλy
  π t interpretation
( −Open
)(ert + rπt t−) +New



δ  − δ  Economy
εAS,t 

(2007)
of
t πt t+
+Consensus
 E t π t + + δ  π t −
 +an
 yt==δα
 +ψ qt +θyMacroeconomic


y + Et yt+ + ( −  ) yt − + ϕ 
t + ε IS,t 
Model.
 + Et πt+ 



(1)  π t = δ E t π t+ + δ  π t − + ( − δ  − δ  )(ert + π t ) + λy t + ε AS,t 



 rt − Et πt+ 

y = α + E y + ( − ) y  r +− ϕ
Et πt+ 
 +ψ qt + θyt + ε IS,t   

t
y
t t+
t−t
   +ψ q + θ

t = α y + Et yt+ + ( −  ) yt − + ϕ 
 y
+ Etπtt+ yt + ε IS,t  


+
E
π

t t+ 

 rt − Et πt+ 
(2)  yr ==αα + E

 ]ψ
(
)
[
y
+
−

y
+
+ θt yt + εIS,t  

ϕ
+
ρr
+
(

−
ρ)
βE
+εqtMP,


y mp
t t+t − 
t −
  t π t + + γyt+
 tt
 + Et πt+ 


 r − Et πt+ 


 +ψ q + θyt + ε IS,t  
yt = α y + Et yt+ + ( − ) yt − + ϕ  t


rt = α mp + ρr t − + (  − ρ) [ βE t π t + + 
γy+t ]E+ πε MP, t   t




 (3) rt = α mp + ρr t −  + (  − ρ) [ βE t π t +t +t+γy t ]+ ε MP, t  




 rt − E t π t + 


− (rt  − E t π t+  ) + φ ca t + ψ  E t  q t +   + ε
 q t = α q + ϕ  

   + E t π t +

 rt − E t π t + 




(4)
q = α q + ϕ  
− (rt − E t π t +  ) + φ ca t + ψ  E t  q t +   + ε q  t  

rt t = α mp
+ ρr t−+ +E (t πt +− ρ) [ βE
π + γy t ]+ ε MP, t  



 rt − E t π t +  t t +



− (rt − E t π t +  ) + φ ca t + ψ  E t  q t +   + ε
 q = α q + ϕ  
t
 + E t π t +









(5)  ca t = α ca + ψ  q t + ω  y t + ω  y t + ε ca t 
ca = α + ψ q + ω y + ω y  + ε 







t
ca
 t
 t
 t
ca  t
 r − E t π t +



q t = α q + ϕ   t
− (rt  − E t π t+  ) + φ ca t + ψ  E t  q t +   + ε q
 er ==αq −+ ψ
pt* q+t ++ptωE t yπ tt ++ ω  y t + ε ca t   
 (6)  ca



t
tt
ca


q − pt +p tpt + p t

 erer
t =
t =t q t −

 
  

 

 


Equation
(1)
is
the
aggregate
supply
equation
with
inflation
determined

 
by past
 and expected inflations (πt-1 and Et πt+1), current output gap (yt), the



*
worldca
), the
exchange
+ψ
q +change
ω  y t +inωthe

 rate (Δer
 t), and
 the 

t = α ca (π
 y nominal
t + ε ca  t 
 inflation
t  t
er
=
q
−
p
+
p

t
t
t
t
 stochastic aggregate supply
  shock  ε AS,t  . In the NNS model,

 aggregate


the



 supply
 equation or Phillips curve is derived from the aggregation of the price
  of firms, based on Calvo (1983). In Calvo (1983), inflation
setting
 decision



was expressed
as a function of expected
inflation and output gap. In the Calvo


er
=
q
−
p
+
p
 setting,t each
t
t
t 
  to change

 price whenever
 a random



his

 price setter is allowed

 42

 








 

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signal is received. However, all price setters do not receive a signal at the same
time, so price revisions are not simultaneous. In any period, only a fraction of
firms will receive the signal and revise their price decisions. Each firm has the
same probability of being one of the firms receiving the signal. Importantly,
it is optimal for an individual firm to take into account the expected future
price level and demand conditions
because its price will remain unchanged

for some time in the future.

Equation (2) is the aggregate demand or IS equation with current output

gap defined as the function of past and future output gaps, real interest
r −Eπ

rate  1t + E tπ t+1 , real exchange rate (qt), the world output gap (yt*), and the
t t +1
aggregate
demand shock  ε IS,t  The aggregate demand equation represents

the current
output gap with

 backward and forward dynamics. Such hybrid

identification
allows us to capture the persistence that can be seen in a time

series. In the aggregate demand equation, backward dynamics are introduced
 formation. However, there is no consensus on

through
some form of habit

whether the consumption habits of households should be internal or external.

“With internal habits a household’s
marginal utility of consumption depends

on the history of its own consumption,
whereas with external habit formation

it depends
on the history of other households’ consumption” (Dennis, 2005,



pp. 1-2).
In equation (2) external habit persistence is considered. This external
habit  formation gives a  micro foundation of backward dynamics in the

 The real exchange rate affects the demand for
aggregate
demand equation.


imports
and
exports,
and
thereby
the
level
of
the
current
output gap.



Equation
(3) is the central
bank reaction function or monetary policy



rule with
the past nominal interbank interest rate, expected inflation, current

output gap and the monetary policy shock term  ε MP,t  The coefficient ρ


prepresents
the degree of smoothness in the interest
 rate change. As mentioned


in Clarida, Gali and Gertler (2000) any weight to past values of the interest


 implies the gradual adjustment of the interest rate
rate in the reaction function


to its equilibrium
value. 

Equation
(4) gives the real exchange rate as a function of the real interest

rate differentials,
current account (cat), the expected

 value of the real exchange


rate itself,
and a random shock term  ε q,t  Equation
(5) determines the


current account as a function of the current real exchange rate, domestic and
B
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İktisat İşletme ve Finans 26 (305) Ağustos / August 2011











43
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
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world output gaps, and the random shock term  ε ca,t 
Finally, equation (6)
is an identity equation which describes the nominal exchange rate in terms of

the real exchange rate and domestic (p) and foreign (p*) price level differences,

all in natural logarithms. The change in the nominal
exchange rate appearing
as     − π  + π   There

in equation (1) can be derived from equation (6)
are six equations and six unknowns: output, interest
rate, inflation, real

exchange rate, current account and nominal exchange
rate.
 
As an alternative to the Arestis model, we also
estimate a model based on

Buncic and Melecky (2008) for the open economy version of the NNS model.


Buncic and Melecky (2008) use a two block model
in which the first block

represents the domestic economy, akin to equations
(1)-(3),
and the rest of the


world is modeled as the closed economy following
Cho and Moreno (2003,
 affects, but is not affected
2006). In this specification the rest of the world

by, the domestic economy. That is, the rest of the
 world is exogenous to the

domestic economy. We estimate this model and compare
the results with the
 
Arestis version of the open economy NNS model.

The NNS model is a system and there are twoways
for estimating structural
parameters of the system. First, each equation in the system can be estimated
separately. In general, a single equation instrumental
variables (IV) method
 
does not provide efficient estimators. System IV
estimators, such as three
 provided that there exists
stage least squares (3SLS), will be more efficient

a sufficient number of good instruments. An alternative
system method, the

Full Information Maximum Likelihood (FIML), on the other hand, is efficient

among all estimators. Linde (2005) illustrates via Monte Carlo simulations
that single equation methods, e.g., GMM estimators,
are likely to be biased
 
and argues that employing the FIML is a way of obtaining better estimates.
We, therefore, determine FIML as the method of estimation in this study, as
 
in many earlier studies.  data for the 1990:Q1-2009:
The NNS model is estimated using quarterly
Q4 period. The interest rate is obtained from the IFS (International Financial
Statistics-IMF) database. The GDP, the consumer price index (CPI, 2005=100)
 OECD. The output gap is
and the current account series are obtained from the
calculated by applying the Hodrick-Prescott filter to the seasonally-adjusted,

logarithmic GDP series. The world output gap is calculated similarly. The
B

We should note that all contemporaneous shock terms are assumed to follow a multivariate normal distribution
since we estimate the model using the Full Information Maximum Likelihood
(FIML) method, as indicated below.

See Henry and Pagan (2004) for a discussion of the econometrics of the NNS models.

GDP: Millions of US dollars, volume estimates, fixed PPPs, OECD reference
year, annual levels, seasonally
adjusted.
İnd
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
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

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interbank interest rate and the CPI-based series are used for the monetary
policy instrument and inflation, respectively. The rest of the world is defined
by G7 data. We compute the weights using each country’s share in Turkey’s
trade, and then normalize and use these weights to calculate the interest rate,
the GDP, and the inflation rate for the rest of the world. The current account
series from the OECD is in current US dollars and is seasonally adjusted. It
is converted into real dollar terms and adjusted in order to obtain the current
account as a percentage of the OECD-based PPP-adjusted real GDP (CA).
The exchange rate is defined as the amount of domestic currency per world
currency and calculated using the weights described above, after which the
natural logarithm is taken. The original series are from the Central Bank of the
Republic of Turkey (CBRT). The real exchange rate series is calculated using
the exchange rate and the domestic and world price series and in logarithm
as well.
4-Results and Discussion
Estimation results of the Arestis model of NNS are given in Table 1.
Firstly, all of the variables with the exception of coefficients on current account
deficit and the real exchange rate in equations (4) and (5) are associated with
the expected coefficient signs, though some are not statistically significant.
Tests for each of the first three coefficients being equal to 1/3 in our aggregate
supply equation indicate that the nulls of the true parameters being equal
to 1/3 cannot be rejected at any conventional significance level.10 This
finding is further strengthened by a Likelihood Ratio test of the joint null
hypothesis that the true values of all first three parameters are equal to 1/3.11
Further, re-estimating the model with the above restrictions on the first three
parameters leaves all the other estimated coefficient values and significance
levels practically unaffected.12 Based on these findings, we conclude that
the hypothesis of economic agents giving the same weight to the first three
variables in Turkey cannot be rejected. The output gap coefficient in the
aggregate supply equation, on the other hand, is insignificant.
İnd
ire
n:
[Ç
uk
ur
ov
a
We convert the current account series from the OECD into constant US dollars using US CPI (2005=100). Then,
we use the IFS GDP series in national currency along with the IFS market exchange rate and convert the series into
current US dollars. We then calculate the real GDP series in 2005 dollars. Next, we compare the real GDP series we
obtained with the OECD-based PPP-adjusted real GDP series and adjust the real current account. Finally, we divide
the adjusted real current account by the OECD-based PPP-adjusted GDP series to obtain the current account as a
percentage of GDP (CA).
We use the CBRT buying rates for the original series.
10 Tests are performed using a standard z-test since Maximum Likelihood estimators are asymptotically normal
estimators.
11 The value of the Likelihood Ratio test is 6.66, which, with 3 degrees of freedom, corresponds to a p-value of
0.0835.
12 The only exception to this is the effect of the real interest rate on the GDP gap becoming significant, which is the
result we obtain below when we drop the insignificant variables from the model.
B
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İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
45
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
Table 1. FIML Estimation of Modified Version of Arestis (2007)
l

Arestis 2007 without insignificant variables
δ1
0,3592
0,1334
0,0071
δ2
0,4491
0,1589
0,0047
λ
0,0121
0,4014
0,9758
αy
0,0142
0,0135
0,2921

0,5030
0,0860
0,0000
φ1
0,4263
0,2830
0,1320
ψ1
0,0011
0,0304
0,9708
0
θ
0,5179
0,2964
0,0806
0
αmp
0,0026
0,0233
0,9097
0
ρ
0,4531
0,1710
0,0081
0,4607
β
1,3169
0,3672
0,0003
1,3130
γ
0,9429
0,6975
0,1765
0
αq
0,0252
0,0563
0,6542
0
φ2
0,3368
1,3163
0,7980
φ
1,2002
1,1432
0,2938
1,0108
0,1415
0,0000
0,0023
0,0076
0,7556
0
0,0454
0,0210
0,0308
0,7117
0,2020
0,2175
0,4753
0,4711
0,1142
0,0000
0,0103
0,0055
0,0654
0,5667
0,0643
0,3150
0,1796
0,0000
0,0004
0,6101
0,0907
0,0000
0,6473
0
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σMP,t
0,0512
0,0526
uk
0,0249
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0,0083
0,9955
0,0279
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0,0500
35
0,0000
ive
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0,0342
0
σIS,t
İnd
0,0795
0
0,0481
46
0,0000
0,0000
0,0484
σCA,t
11
0
σAS,t
σq,t
:35
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0,0193
[Ç
B
ω2
0,1450
0,1658
Ün
ω1
0,3394
0,0000
ov
a
ψ3
ur
αca
P Value
0,0720
il
ψ2
Standard Error
+0
30
0
Coefficient
se
Coefficient Standard Error P Value
55
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Arestis 2007
0,0943
0,0967
0,0223
0,0214
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According to the aggregate demand equation, the past and future output
gaps have the same weights. The real interest rate and real exchange rate
coefficients have the right signs but are insignificant. Lastly, the world
output gap has the expected sign and is marginally significant. Equation (3)
shows that the Central Bank responds to expected inflation by increasing the
interest rate around 0.72 percent. The output gap coefficient in equation (3) is
insignificant, implying that the Central Bank does not respond to fluctuations
in the output gap. In equation (4) the real exchange rate is not influenced by
the current account and the difference between the real domestic and real
world interest rates, but only by the expected real exchange rate. The last
equation shows that the depreciation of the real exchange rate increases the
current account deficit, contrary to the theoretical expectations. Increases
in the domestic gap raise the current account deficit, a fact consistent with
observations for the Turkish economy.
The second column of Table 1 presents results when insignificant
coefficients are eliminated from the model one by one, starting with the
coefficient that has the highest p-value.13 In this version of the model, the
effect of the real interest rate on the GDP gap becomes significant and has the
right sign, consistent with theoretical expectations. The effect of the world
gap on the domestic gap, on the other hand, becomes insignificant. Overall
our results are consistent with the other empirical studies, such as Giordani
(2004), Buncic and Melecky (2008), and Yıldırım, et al. (2010).
Figure 2 presents the actual and predicted values of the model’s endogenous
variables. Actual and predicted values coincide well for output gap but differ
for inflation and interest rate variables, especially in times of economic crises.
For the current account deficit, on the other hand, the actual and predicted
values coincide better during times of economic crises and differ at other
times. The model performs the worst in terms of the actual and predicted
values of the real exchange rate.
Given the poor performance of the model, especially in the real exchange
rate equation, we perform a Zivot and Andrews (1992) unit root (ZA) test,
allowing a structural break in the mean and the trend of the real exchange
rate and reject the null of the unit root. The ZA test picks the break point
of the real exchange rate consistently as the 2000:Q4 period. We apply the
Quandt-Andrews type of tests, called SupF, for structural breaks in the mean
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13 Here we eliminate the coefficient with the highest p-value and re-estimate the model, then eliminate the coefficient in the re-estimated model with the highest p-value and continue this process until all the insignificant coefficients at the 10% level are eliminated. It should be noted that the p-values for each re-estimated model are different,
and some of the coefficients with a lower p-value in the initial model become insignificant in the final model.
47
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and mean and trend of the real exchange rate (by calculating a Chow type
test statistic for every point from the 10th percentile of the sample to the 90th
percentile of the sample and picking the largest F-value).14 Additionally, we
test the real exchange rate model of equation (4) and a modified version of
equation (4) by adding a time trend. In all the cases, again the period 2000:
Q4 gives the largest F-value with p-value near zero. Thus, we conclude that
the parameters of the exchange rate equation are different before and after
the 2001 crisis. We then re-estimate the model with the new exchange rate
equation (4`) given below, where D is the dummy variable and takes the value
of 1 starting with 2001:Q1.

(
11
)
 


)
/08
/20
(
11
 r − Et πt+
 r − Et πt+

qt = α q + α dm + ϕ  t
− rt − Etπ t+  + τD t
− rt − Etπ t+
 + Et πt+
 + Et πt+

+ φcat + τ  Dcat  +ψ qt + + τ  Dqt +  + τ trend + τ  Dtrend + ε qt
ih:
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], T
 results presented in Table 2 reveal that the signs and significance
The
of the original coefficients are essentially the same, except the world gap
coefficient
in equation (2) turning out to be insignificant and the intercept and

the current account coefficient in equation (4) becoming significant. When

the actual and the predicted values of the model’s endogenous variables are

compared
(Figure 3) with the benchmark model, the model’s performance

improves
significantly, especially in terms of the exchange rate variable. Even
if the insignificant
coefficients are excluded, the model performs well, as the

differences
between
the actual and predicted values are essentially unaffected.

The above result illustrates that it is essential to test and account for structural
  for meaningful comparisons.
changes
Ün
π t = δ Et π t+1 + δ  π t −1 + ( − δ  − δ  )qt + λy t + ε AS,t 





ur
ov
a
(7)  π t = δ Et π t+1 + δ  π t −1 + ( − δ  − δ  )qt + λy t + ε AS,t 
B
uk
 
[Ç

ire
n:
 r − Et π t+1 

*
(8) yt = α y + Et yt+1 + (1 −  ) yt −1 + ϕ  t
 1 + E π  +ψ qt − + θ yt + ε IS,t 
 r − Et πt+1 

t t+1
 +ψ qt − + θ y*t + ε IS,t 
yt = α y + Et yt+1 + (1 −  ) yt −1 + ϕ  t

1
+
E
π

t t+1 


14 See Andrews
(1993) and Hansen (1997&2000) for a detailed discussion.



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İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
48

r
t = α mp + ρr t − 1 + (1 − ρ )[ βE t π t + 1 + γy t ] + ε MP, t  
 r t = α mp + ρr t − 1 + (1 − ρ )[ βE t π t +1 + γy t ]+ ε MP, t  














l



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
+0
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)
)
)
)
:35
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(
(
(
(
11
)
)
)
)
[
[
[
[
se
(
(
(
(
B
İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300
r1t +
− Ett π tt++11 

 +ψ qt − + θ y*t + ε IS,t 
y
t = α y + Et y t+1 + (1 −  ) y t −1 + ϕ 
rt1−+EEttππtt++11 

 +ψ qt − + θ y*t + ε IS,t 
y
t = α y + Et y t+1 + (1 −  ) y t −1 + ϕ 

1
+
E
π
t t+1 



rt = α mp + ρr t − 1 + (1 − ρ )[βE t π t +1 + γy t ]+ ε MP, t  


 İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
r = α mp + ρr t − 1 + (1 − ρ )[βE t π t +1 + γy t ]+ ε MP, t  

t

rt = α mp + ρr t − 1 + (1 − ρ )[βE t π t +1 + γy t ]+ ε MP, t  


(9) rt = α mp + ρr t − 1 + (1 − ρ )[ βE t π t +1 + γy t ]+ ε MP, t  

 *
*
*
*
*
*
*
*
π = δ 1 E t π t + 1 + (1  δ 1 )π t  1 + λ y t + ε AS, t  


  *t
π t = δ 1* E t π *t + 1 + (1  δ 1* )π t* 1 + λ * y *t + ε *AS, t  


*
*
*
*
*
*
*
*
(10) π t = δ 1 E t π t + 1 + (1  δ 1 )π t  1 + λ y t + ε AS, t  



π *t = δ 1* E t π *t + 1 + (1  δ 1* )π t* 1 + λ * y *t + ε *AS, t  


 *
y t = α *y +  * E t y *t + 1 + 1   * y t*1 − ϕ * rt* − E t π *t + 1 + ε *IS, t
 
 *
*
*
*
*
*
*
*
*
*
(11) y t = α y +  E t y t + 1 + 1   y t 1 − ϕ rt − E t π t + 1 + ε IS, t  
 y * = α * +  * E y * + 1   * y * − ϕ * r * − E π * + ε *
t
y
t t+1
t 1
t
t t+1
IS, t 

 *
*
*
*
*
*
*
*
*
*
y t = α y +  E t y t + 1 + 1   y t 1 − ϕ rt − E t π t + 1 + ε IS, t
 
 *
*
* *
*
*
*
* *
*
(12) rt = α mp + ρ rt  1 + (1  ρ ) β E t π t + 1 + γ y t + ε MP, t  

 *
*
* *
*
*
*
* *
*
rt = α mp + ρ rt  1 + (1  ρ ) β E t π t + 1 + γ y t + ε MP, t  

 r * = α * + ρ * r * + (1  ρ * ) β * E π * + γ * y * + ε *  

t 1
t
mp
t t+1
t
MP, t
*
*
* *
*
*
*
* *
*
rt = α mp + ρ rt  1 + (1  ρ ) β E t π t + 1 + γ y t + ε MP, t  



For comparison
purposes we estimate a modified version of the Buncic


and Melecky (2008) open economy NNS model described by equations (712). Here,
the difference from the Arestis model is the addition of the real

exchange rate, qt in equation (7) and the replacement of qt by qt −1 in equation

(8). Equation (9) is the same as in the Arestis model, and the equations (10-12)
describe the standard closed economy NNS model for the rest of the world.
49




İktisat İşletme ve Finans 26 (305) Ağustos / August 2011




l


se
         
11
/20

01
/08

ih:
ar
ge



35






         

ov
a
Ün
         
ite

rs
il

ive

si]
, IP
:[
19


4.1
3.2
55

         

.19


], T


11
 
         

:35
:29



+0
30
0


B
uk
[Ç
n:
ire






Figure


50
ur

İnd
İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300

2. Actual and fitted values of modified version of Arestis (2007)
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
Table 2. FIML Estimation of the Modified Version of Arestis (2007) with
  
         
Structural
Break
Standard Error
P Value
δ1
0,3126
0,1882
0,0967
δ2
0,4878
0,1787
λ
0,0565
0,3459
0,8702
αy
0,0204
0,0166
0,2202

0,4451
0,1156
0,0001
φ1
0,4629
0,3088
0,1339
ψ1
0,0117
0,0361
0,7442
θ
0,5022
0,3408
0,1406
αmp
0,0001
ρ
0,4377
l
Coefficient
0,9965
/20
0,0309
0,0576
0,1281
0,0428
1,1593
0,5571
0,1695
0,9616
0,7312
1,1256
0,5159
3,0514
1,1021
0,0056
1,7640
0,4398
0,1700
0,0033
0,3314
0,2917
0,0014
0,7098
0,0069
0,0803
φ
τ2
1,3626
ih:
ar
], T
35
4.1
.19
τ1
3.2
φ2
:[
19
αdm01
01
0,4780
0,9051
ge
1,3681
1,0384
55
/08
0,2305
γ
αq
0,0042
0,2513
0,0028
0,0374
0,8600
τ3
0,3494
τ4
0,0005
τ5
0,0120
αca
0,0003
0,0093
0,9695
ψ3
0,0525
0,0257
0,0414
ω1
0,7195
0,2071
0,0005
0,5210
0,8619
ite
rs
ive
Ün
ov
a
ur
ire
n:
[Ç
uk
0,0906
İnd
σAS,t
σIS,t
σMP,t
σq,t
σCA,t
si]
, IP
0,4988
il
ψ2
ω2
+0
30
0
:35
:29
11
11
se
0,0064
β
B
İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300

0,0484
0,0286
0,0521
0,0730
0,0224
51
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011





l

İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300

se
         
11
/08
/20

01

ih:
ar
ge

:[
19
3.2


         
si]
, IP
35





         

ov
a
Ün


ite

rs

ive
il


4.1
55

          
.19


], T


11


         

:35
:29



+0
30
0


ur
uk
B

n:
ire

İnd

[Ç

Figure 3. Actual and fitted values of Arestis (2007) with structural break
in equation (4)

52


l
The estimation results of the Buncic and Melecky (2008) model are given
in Table 3. The coefficients generally have the expected signs, and overall the
results are consistent with the results of the Arestis model. What is different
from the Arestis model is that the point estimates imply noticeably stronger
forward dynamics in the aggregate supply equation and stronger backward
dynamics in the aggregate demand equation.
0,0176
0,0203
0,4373
0,5369
0,8929
0,0697
0,0195
0,3668
0,0134
0,1854
0,0184
0,0874
0,4226
0,8690
0,0120
0,2660
0,1724
0,0199

0,3900
0,1680
φ
0,4718
0,4875
ψ
0,0033
0,0240
0,8905
0,0241
0,0606
0,6903
θ
0,0019
0,7028
0,9977
0,0210
0,6820
0,9754
αmp
0,0121
0,0358
0,7353
0,0084
0,0327
0,7976
0,0331
0,4014
ge
0,2799
], T
0,4389
35
0,4742
4.1
0,3331
0,2135
0,0901
0,4281
0,2009
1,1877
0,3700
0,0013
1,2169
0,3438
γ
0,4504
0,8225
0,5839
0,5002
1,0494
δ1*
0,5498
0,1236
0,0000
0,5474
0,1173
0,0000
*
0,0133
0,0648
0,8363
0,0155
0,0691
0,8224
αy*
0,0003
0,0009
0,7121
0,0003
0,0009
0,6940
*

0,4821
0,0796
0,0000
0,4803
0,0870
0,0000
φ*
0,0479
0,1612
0,7663
0,0494
0,1696
0,7706
55
3.2
:[
19
si]
, IP
ite
0,0004
0,6336
0,0003
0,8338
0,0000
0,0004
0,8626
0,9530
0,0324
0,0000
0,9536
0,0335
0,0000
*
0,6558
0,8930
0,4627
0,6761
0,9865
0,4931
γ*
0,9690
0,9549
0,3102
0,9686
0,9950
0,3303
IS,t
σ* MP,t
Ün
ov
a
ur
0,0033
uk
0,0547
σ* AS,t
[Ç
σMP,t
n:
0,0281
ire
0,0541
σIS,t
İnd
σAS,t
ive
0,0000
ρ*
β
*
rs
αmp
.19
0,3619
il
ρ
β
*
:35
:29
0,0722
0,3582
0,0326
11
λ
αy
0,0343
11
0,2234
/20
0,4773
P Value
/08
0,5205
δ2
Standard
Error
0,2095
01
P Value Coefficient
ih:
δ1
Standard
Error
0,2458
λ
σ
With ( ert + π t* )
ar
Coefficient
+0
30
0
With Real Exchange Rate
se

Table
3. FIML Estimation of Buncic and Melecky (2008) Version of NNS
B
İndiren: [Çukurova Üniversitesi], IP: [193.255.194.135], Tarih: 01/08/2011 11:35:29 +0300
İktisat İşletme ve Finans 26 (305) Ağustos / August 2011
0,0483
0,0284
0,0542
0,0034
0,0023
0,0023
0,0008
0,0008

53
+0
30
0
se
l
  
When we replace the real exchange rate, qt in equation (7) and qt −1
in equation (8) with    + π   and its first lag, respectively, all point
estimates are essentially the same as their Arestis model counterparts. The

only noteworthy difference
is the insignificance of the world gap coefficient
and again relatively stronger-backward
dynamics in the IS equation. Thus,

overall it is reasonable to say that estimates of the main parameters of the
NNS model are robust across the specifications of both the Arestis and the
Buncic and Melecky models
and their several variations.

İnd
ire
n:
[Ç
uk
ur
ov
a
si]
, IP
ite
rs
ive
Ün
il
:[
19
ih:
ar
], T
35
4.1
.19
3.2
55
ge
01
/08
/20
11
11
:35
:29

5-Conclusion
The results of the analysis
for the Turkish economy for the 1990:Q1
2009:Q4 period are summarized as follows:
 estimation results of the Arestis (2007) and the
i. According to the
Buncic and Melecky (2008)
versions of NNS models, the hypothesis that the

economic agents in Turkey give similar weight to past and future inflations in

their decision making process
cannot be rejected.
ii. The output gap does not have any statistically significant impact on
inflation.

iii.Backward and forward dynamics have similar weight in the aggregate
demand equation.

iv. The real interest rate and the real exchange rate do not have a significant

impact on the output gap for all but one model. For the Arestis model

without insignificant variables,
the real exchange rate becomes marginally
significant.

v. In all the specifications, the Central Bank gives significant weight to
inflation expectations in the monetary reaction function but does not respond
to fluctuations in the output
gap.

vi.The actual and fitted values are better matched with the structural
 equation.
break in the exchange rate
These results clearly
 indicate that the NNS model can provide a useful
framework to explain the fluctuations in the Turkish economy. It is equally

clear that further investigations
regarding the potentials of alternative NNS
models to better mimic the Turkish economy are needed. In particular, the
impact of the real exchange rate on current account and conversely current
 are controversial. Future research could focus on
account on exchange rate
exchange rate and current
 account dynamics to better capture the fluctuations
of the Turkish economy.

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