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CENTRAL BANK OF THE REPUBLIC OF TURKEY
WORKING PAPER NO: 11/04
The Interaction Between Monetary
and Fiscal Policies in Turkey:
An Estimated New Keynesian DSGE
Model
January 2011
Cem ÇEBİ
© Central Bank of the Republic of Turkey 2011
Address:
Central Bank of the Republic of Turkey
Head Office
Research and Monetary Policy Department
İstiklal Caddesi No: 10
Ulus, 06100 Ankara, Turkey
Phone:
+90 312 507 54 02
Facsimile:
+90 312 507 57 33
The views expressed in this working paper are those of the
author(s) and do not necessarily represent the official views of the
Central Bank of the Republic of Turkey. The Working Paper Series
are externally refereed. The refereeing process is managed by the
Research and Monetary Policy Department.
The Interaction Between Monetary and Fiscal Policies in Turkey:
An Estimated New Keynesian DSGE Model
Cem Çebiy
Central Bank of the Republic of Turkey
Abstract
This paper estimates a New Keynesian open economy DSGE model for Turkey by using Bayesian
estimation technique for the period of 2002:q1 - 2009:q3. It studies …scal and monetary policy
interactions and their role in stabilisation of the economy using a small-scale model following the
methodology outlined in Lubik and Schorfheide (2007). The general features of the model can be
summarised as follows: Calvo style nominal price rigidities, perfect exchange rate pass-through,
complete international asset markets, rule of thumb price setters and distortionary taxation.
The parameter estimates show that the monetary authority reacts to in‡ation but only weakly
reacts to the output gap. The degree of interest rate smoothing is high. Fiscal policy has contributed
to the debt stabilization but there is no evidence on active …scal stabilization of output gap.
Key Words: Monetary and Fiscal Policy, Macroeconomic Stabilisation, Bayesian Estimation
JEL Reference Number: E52, E61, E63
I would like to thank Tatiana Kirsanova, Ümit Özlale and the anonymous referee for useful comments and suggestions.
I would like to also thank participants of seminar at Central Bank of the Republic of Turkey for comments. The paper
represents the views and analysis of the author and should not be thought to represent those of Central Bank of the
Republic of Turkey. Any errors are mine.
y
Address: Central Bank of the Republic of Turkey, Head O¢ ce, Istiklal Caddesi, 10, Post Code: 06100,
Ulus/Ankara/TURKEY; e-mail: [email protected]
1
1
Introduction
After two subsequent …nancial crises Turkey started year 2001 with budget de…cit of 11.9% of GDP,
and a double-digit in‡ation rate of 68.5% per annum was reached by the end of the year. The share
of net stock of public debt in the GDP was 66.3%, and most of the debt was short-term. Remarkably,
by the end of 2009 in‡ation fell to 6.5% per annum and by the end of 2008 the de…cit to GDP ratio
was reduced to just 1.8%. Arguably, the stabilisation has to be attributed to the “Strengthening the
Turkish Economy” programme that took o¤ in 2001, after the Central Bank of Turkey gained formal
independence. This programme was conducted under the ‡oating exchange rate and an informal
(implicit) in‡ation targeting regime, supported by both monetary and …scal policies. In January 2006,
after the initial success of the stabilization programme, Turkey introduced an explicit in‡ation target.
This paper assesses the extent to which the observed stabilization in Turkey can be attributed to
monetary and …scal policy mix in the post-crisis period. Turkey is one of the European Union candidate
countries, and the success of the stabilization makes further integration of Turkey with European
countries more realistic. As such integration is impossible without convergence of main economic
mechanisms and policies, it is imperative to investigate similarities and di¤erences of transmission
mechanisms in Turkey with those in the EU countries. There is virtually no empirical research on
policy transmission mechanisms in Turkey that uses (small-scale) internally consistent models. The
(only) exception is Ortiz et al (2009), but the model employed there does not include …scal policy and
can be miss-speci…ed in an important way.
We use a standard small-scale open economy New Keynesian model, adopted from Lubik and
Schorfheide (2007) but modi…ed to include e¤ects of …scal policy1 . The model assumes Calvo-style
nominal price rigidities but with rule-of-thumb price-setters, perfect exchange rate pass-through, complete international asset markets. Importantly, …scal policy has to satisfy an important intertemporal
solvency constraint. Lubik and Schorfheide (2007) have demonstrated that despite simplicity and
potential misspeci…cations small DSGE models, such as one we use here, can capture robust empirical
relationships. Because the main aim of this paper is to estimate parameters of policy interactions,
we keep the model of the economy simple, and the model equations essentially work as identifying
restrictions for policy reactions. A microfounded model allows us to derive theory-based monetary
and …scal policy rules. We use both instruments of …scal policy, government spending and labour income taxes, and assume joint rules-based monetary-…scal stabilisation policy. The adopted empirical
approach, the Bayesian estimation, is system-based and allows us to account for important e¤ects of
government solvency constraint in identi…cation of …scal policy.
Our analysis demonstrates that over the post-crisis period monetary policy in Turkey reacted to
in‡ation aggressively. There is a literature on the issue that high level of debt stock prevents the
1
The model is a modi…ed version of Gali and Monacelli (2005) and includes …scal policy as in Fragetta and Kirsanova
(2010).
1
Central Banks to implement an independent monetary policy. This is because if the Central Banks
increase policy rates, this would also increase debt burden of the budget and so jeopardise debt
sustainability2 . In spite of the fact that the concerns about the sustainability of domestic debt stock
maintained in the early 2000s, they have gradually alleviated over time thanks to implementation of
strong …scal discipline. Hence, this situation has caused the increase in the e¢ ciency of the monetary
transmission mechanism in Turkey3 .
There is also a weak evidence of output gap stabilisation. We …nd that …scal policy played an
important role in debt stabilisation, but we did not …nd any evidence on active stabilisation of output
gap by …scal means. Overall, we …nd that monetary and …scal policy mix in Turkey in 2001-2009 was
similar to the one in many developed countries, as reported in Gali and Perotti (2003).
This paper is structured in the following way. The New Keynesian open economy DSGE model is
outlined in section 2. Section 3 discusses the estimation methodology, data and the choice of priors.
Section 4 presents the empirical results. Finally, section 5 concludes.
2
The Model
2.1
The Behaviour of the Private Sector
A small open economy is inhabited by a representative, in…nitely lived household who seeks to maximise
the expected present discounted value of the lifetime utility subject to intertemporal budget constraint:
!
1
X
Ct1
G1t
Nt1+'
t
E0
+
(1)
1
1
1+'
t=0
where
2 (0; 1) is the household discount factor,
is inverse intertemporal elasticity of substitution
in consumption, ' is inverse labour supply elasticity with respect to real wage and
is a relative
weight on consumption of public goods. The aggregate variables in the utility function, Ct , Gt and
Nt are private consumption, government spending and labour supplied (hours of work), respectively.
Household’s intertemporal budget constraint is standard and can be written as follows:
Pt Ct + Et fQt;t+1 Dt+1 g + T
Dt + (1
t ) Wt Nt
(2)
where Qt;t+1 = (1=1 + rt ) is one-period ahead stochastic discount factor, rt is nominal interest rate, T
and
t
represent constant lump-sum taxes and income tax rate, respectively. Wt is nominal wage, Dt
is nominal portfolio, Pt is consumer price index (CPI) and Ct is composite consumption index which
consists of index of domestically produced goods (CH;t ) and index of imported goods (CF;t ). These
goods are produced by monopolistically competitive …rms.
2
There are some studies which stresses the importance of …scal dominance in the implementation of the monetary
policy in Turkey. See Kara (2008) and Ersel & Özatay (2008) for further information about the Turkish experience with
implicit in‡ation targeting regime.
3
See Karasoy, Kunter & Us (2005) and Aktaş, Kaya & Özlale (2010) for further information about the importance of
…scal stance and the associated risk premium in monetary transmission mechanism in Turkey.
2
A forward looking open economy IS curve, which is found in Gali & Monacelli (2005, 2008),
is described in terms of output instead of consumption by using national income identity and risk
sharing condition. A log-linearised IS curve in terms of deviations from steady state can be expressed
as follows:
n^ o
n ^ o
^
y t = E t y t+1
Et
g t+1 + ($
where
(1
)+ $
and $
+ (1
1) ct
c
)(
goods produced in di¤erent foreign countries.
gt =
ln (1
= yt
Et
n^
H;t+1
o
(3)
> 0 denotes elasticity of sub-
measures the share of domestic consumption allo-
cated to imported goods (degree of openness) and
put y t = ln Yt =Y ;
^
rt
1) : Parameter
stitution between domestic and foreign goods,
^
1
^
1) (
re‡ects elasticity of substitution between the
Endogenous vaiables are de…ned as follows: out-
y, where y denotes steady state value of yt , government spending
Gt =Yt ), nominal interest rate rt and domestic in‡ation
H;t
= ln (PH;t =PH;t
1 ).
I use
domestic in‡ation instead of CPI in‡ation by substituting out import component of CPI in‡ation
with the help of risk sharing condition. Domestic price, PH;t ; is represented by GDP de‡ator and
ct = yt
gt denotes exogenous world consumption (output), which follows AR(1) process. In this
study, all foreign variables are indexed with an asterisk,
( ).
I obtain a forward looking open economy
IS curve in the gap form as follows:4
n~ o
~
y t = Et y t+1
~
^
^n ~
Et
n
~
g t+1
o
1
~
rt
^n
^
Et
n~
~
H;t+1
o
(4)
^
~
where y t = y t y t , rt = rt rt : We can write g t+1 = g t+1 and
0:5 Finally,
^n
^n
y t and rt denote
H;t+1
=
^
^
H;t+1
since g n t+1 =
^
n
H;t+1
=
natural level of output and of nominal interest rate, respectively. These
are the equilibrium level of output and interest rates in absence of nominal rigidities, which can be
written in the following way:6
^n
yt =
^n
rt =
(1 + ') ^
at
( + ')
^n
Et y t+1
(
(
)^
c
+ ') t
^n
yt
+
(5)
($
1) (
^
c
1) ct
(6)
where at is log of technology process, At :
4
Di¤erent from Christo¤el, Coenen & Warne (2008), who use a trend-based output gap measure, we use another
output gap measure calculated as a di¤erence between actual ouput, which is demeaned, detrended and seasonally
adjusted, and ‡exible price level (natural rate) of output by following e.g. Smets & Wouters (2003).
5
We assume that government spending and tax are zero in ‡exible price economy, which means that there is no budget
de…cit or surplus under the ‡exible price equilibrium. See Fragetta & Kirsanova (2010) for the assumption related to
natural level of government spending.
6
It is possible to also show natural level of interest rate in terms of only productivity and world output shocks if we
^n
substitute out the potential output: rt =
(1+')( a
(
+')
1) ^
at +
3
' ($ 1)
(
+')
(
^
c
1) ct
2.2
The Firm Behaviour and The Price Setting
There is a continuum of identical monopolistically …rms in the economy. Each …rms produces a
di¤erentiated good using linear technology. So j t h …rm’s production function can be written as
follows:
Yt (j) = At Nt (j)
(7)
Following Calvo (1983), we assume that a fraction 1
of the …rms can set a new price in each
of them keeps its price unchanged.7 In other words, each period every
period, hence, a fraction
…rm may set a new price with probability 1
and this probability is independent of the time
elapsed since the last price setting. Therefore, 1= (1
) shows average duration that prices are …xed.
Moreover, di¤erent from the standard Calvo framework we also include backward looking behaviour
in price setting process by following Gali & Gertler (1999) in order to take into consideration in‡ation
persistence. We assume that there are two types of …rm in the economy. While a fraction of 1
the price setters, who change their prices each period with probability 1
of
, behave optimally as in
standard Calvo model, when setting their prices, the remaining fraction ( ) prefer to reset their prices
by taking into account backward looking (rule of thumb) behaviour.8 The price, pbH;t , which is chosen
by rule of thumb price setters, can be written as in Gali & Gertler (1999):
pbH;t = PH;t
where PH;t
1
1
PH;t
PH;t
f
= (PH;t
1
(8)
2
b
PH;t
1
1)
f
(forward looking, PH;t
1)
is the aggregate prices chosen in period t 1 by both optimizing
1
b
and rule of thumb (backward looking, PH;t
1)
price setters. Therefore, the
rule of thumb price setters take into account past period in‡ation rate (
well as aggregate price PH;t
occured in period t
1
H;t 1
= PH;t
1 =PH;t 2 )
as
1, when they reset their prices in period t. The
existence of backward looking …rms besides forward looking …rms allows us to obtain a log-linearised
open economy hybrid Phillips curve in terms of deviations from steady state as follows:
n^
o
^
^
b^
f
=
+
E
t
H;t
H;t 1
H;t+1 + mct + t
^
where
b
=
cost and and
+ ') y t
+ (1
t
^n
^
mct = (
=
(1
)) ,
ln (1
^
yt
f
=
gt +
+ (1
t =Yt )
(1
^
))
t
and
=
(1
)(1 )(1 )
+ (1 (1 )) .
is a log-linearized tax rate.
t
(9)
(10)
^
mct denotes real marginal
represents a cost push (mark-up)
shock which we include in the Phillips curve by following, among others, Smets & Wouters (2003,
2007), Beetsma & Jensen (2004), Ireland (2004) and Fragetta & Kirsanova (2010). Following Smets &
7
Parameter measures the degree of price stickiness in the economy.
Christiano, Eichenbaum & Evans (2005) take into account lagged dynamics in the Phillips curve. Assuming that a
fraction 1
of the …rms can set a new price optimally in each period as in Calvo model, the remaining part (a fraction
) set their prices by using the previous period’s in‡ation rate.
8
4
Wouters (2003) and Fragetta & Kirsanova (2010) we assume that cost push shock is an independent
and identically-distributed (i.i.d.) shock9 . According to equation (10), government spending and
income tax as well as output gap directly a¤ect real marginal cost and hence they indirectly a¤ect
in‡ation via equation (9)10 . The slope coe¢ cient of Phillips curve
shows sensitivity of domestic
in‡ation with respect to real marginal cost. In addition to current real marginal cost, future expected
in‡ation and past in‡ation re‡ecting in‡ation inertia enter the current domestic in‡ation equation.
b
The structural reduced form parameters
,
f
and
are de…ned in terms of three deep parameters of
the model, ; and : When the degree of backwardness, , is equal to zero, one can obtain a forward
looking open economy Phillips curve, however, when
is di¤erent from zero a hybrid Phillips curve
is found. Another interesting feature depends on the value for discount factor,
b
sum of
and
f
. When
will be 1. Additionally, the total value of these components will be between
= 0) and 1 (when
= 1 the
(when
= 1): As stated in Amato & Laubach (2003), due to the fact that the value of
discount factor is very close to 1,
b
f
and
can be interpreted as relative weights on past and expected
future in‡ation, respectively. The more share of rule of thumb price setting …rms increases the more
weight on past in‡ation (in‡ation inertia) raises. Moreover, an increase in the number of rule of thumb
price setters and a high degree of price stickiness reduce the sensitivity of current domestic in‡ation
to current real marginal cost.
2.3
The Policy
2.3.1
The Monetary Policy Rule
Following Smets & Wouters (2003, 2007), we de…ne a simple Taylor-type interest rate rule based on
in‡ation and output gap instead of assuming that monetary authority focus on minimising a loss
function.11
^
rt =
^n
^
r
rt
1
rt
1
+ (1
r)
r
^
^
H;t
+ ry y t
^n
^n
+ rt + "rt
yt
^n
where rt represents natural level of nominal interest rate and
r
(0
r
(11)
1) is interest rate smoothing
coe¢ cient and "rt is an i.i.d. interest rate shock, which can be interpreted as the non-systematic part
of the monetary policy. Parameters r and ry show the Central Bank’s preference about in‡ation
and output gap. Since the main aim of the Central Bank is to establish price stability, the parameter
r should be higher than ry . This kind of monetary policy rule implies that Central Banks change
9
Ireland (2004) used a cost push shock, which follows AR(1) process, with a forward looking Phillips Curve. On the
other hand, Smets & Wouters (2007) used a cost push shock, which follows ARMA(1,1) process, with a hybrid Phillips
Curve for the US economy. They indicate that since in‡ation shows high-frequency ‡uctations, MA term is included in
order to capture them.
10
Tax is a cost element for a …rm. An increase in income tax rate directly increases real wages which also a¤ects …rm’s
real marginal cost. Therefore, an increase in real marginal cost is re‡ected in the price of product and so in‡ation.
11
Smets & Wouters (2003) include change in in‡ation and change in output gap, Smets & Wouters (2007) include
change in output gap in addition to in‡ation and output gap itself in their monetary policy rules.
5
nominal interest rates in response to deviation of in‡ation from its steady state value and deviation of
output from its natural level. Additionally, Central Banks also take into account past value of nominal
interest rates (when
r
6= 0) when they reset their current nominal interest rates. The high value for
the degree of interest rate smoothing reduces the contemporary responsiveness of the nominal interest
rates to in‡ation and output gap.
2.3.2
The Fiscal Policy Rules
Following Muscatelli & Tirelli (2005) we consider a backward looking form for the …scal policy reaction
functions by taking into account lagged responses of …scal policy to economic activity.12
We also
assume smoothing of …scal instruments, as Favero & Monacelli (2005) and Forni, Monteforte & Sessa
(2009).
^
gt =
^
=
t
^
g gt
Parameters
^
t 1
gy y t
g
)
+ (1
and
g
^n
^
1+ 1
1
yt
1
yt
yt
+ gb bt +
1
+
^n
^
y
^
1
^
b bt
+
g
t
(12)
t:
(13)
denote the degree of …scal smoothing. Parameters gy and
y
demonstrate
the sensitivities of government spending and tax to past value of output gap. Parameters gb and
correspond to feedback coe¢ cients on unobservable debt stock and
g
t
and
t
b
are i.i.d. government
spending and tax shocks, which represent the non-systematic component of discretionay …scal policy
or discretionary exogenous deviations from the …scal rules. According to government spending and
tax rules described above, the …scal authority has two objectives, namely output stabilisation and
debt stabilisation. Depending on the degree of …scal smoothing the magnitude of the responsiveness
of spending and tax with respect to debt and output gap changes. For example, the increase in the
degree of …scal smoothing results in the decline in the sensitivity of the government spending and tax
to output gap and debt.
2.3.3
The Government Solvency Constraint
Finally, the model is completed by a …scal constraint. As in Kirsanova et al (2007) and Fragetta &
Kirsanova (2010), a log-linearised government solvency constraint (…scal constraint) can be expressed
12
Muscatelli & Tirelli (2005) describe the …scal rules for government spending and tax as follows:
^
gt =
^
t
^
1 gt 1
= '1
^
^
^
2 yt 1
^
+
^
t 1
where g t and
'2 y t
^
1
3 bt
^
+ '3 b t
^
^
t
represent government spending and tax, y t
6
1
denotes output gap and bt stands for debt.
as:
^
2
^
14
bt
^
where bt = ln (Bt =PH;t
1 ),
^
bt+1 = rt +
H;t
+ (1
)
^
^
t
yt +
C
B
^
gt
^
t
3
5
(14)
Bt is nominal debt stock, B is the steady state debt to GDP ratio, C is
steady state consumption to GDP ratio.
As a result, an open economy New Keynesian DSGE model consists of a forward looking IS curve,
a hybrid Phillips curve, monetary and …scal policy rules and a government solvency constraint. We
have …ve observable variables, output, in‡ation, nominal interest rate, tax to GDP ratio and spending
to GDP ratio. We treat domestic debt stock, natural level of output and of nominal interest rates as
unobservable variables. Stochastic behaviour of the system is driven by six exogenous disturbances,
namely productivity (technology) shock, world output shock, mark-up shock, interest rate shock, tax
shock and spending shock.
3
Estimation Methodology
3.1
Econometric Methodology
There are di¤erent methods to estimate and evaluate DSGE models in the literature. As stated
in An & Schorfheide (2007), these techniques are summarised as calibration, generalized method of
moments (GMM), full-information likelihood based estimation, Bayesian estimation and minumum
distance estimation based on the distance between impulse response functions received from VAR and
DSGE model. Following An & Schorfheide (2007) and Mancini-Gri¤oli (2007) I use the Bayesian
estimation technique to estimate a linearised DSGE model.13 It gives us several advantages over the
competing techniques. First, Bayesian estimation allows one to use a prior distribution that brings
additional information in the estimation process. Moreover, as stated in Mancini-Gri¤oli (2007),
including the priors in the estimation process helps identifying parameters of the model. Second,
while the GMM estimation is based on a single equation, Bayesian approach is system based, which
allows us to take bene…t from the advantages of the general equilibrium approach (Rabanal & RubioRamirez (2005)). Additionaly, the existence of government solvency constraint serves as an important
identifying restriction in the model, and the need to take it into account prevents the use of a equationbased estimation.14 Third, a Bayesian approach shows better performance than GMM and maximum
likelihood in small samples, see Rabanal & Rubio-Ramirez (2005).
The estimation procedure is clearly explained in Koop (2003), An & Schorfheide (2007) and
Mancini-Gri¤oli (2007) and consists of several steps. From the reduced form solution of the model I
13
An introduction to Bayesian Analysis can be found in Hamilton (1994) and Koop (2003).
The presence of debt accumulation equation, which is potentially explosive, may impose strong restrictions on the
values of the coe¢ cients of the …scal policy rules. Therefore, it is only a system-based approach can ensure su¢ cient
identifying restrictions.
14
7
obtain a state space representation of the model where unobserved state variables are mapped into
the observed data. I apply the Kalman …lter to the reduced form in order to calculate the likelihood
function of the observed data. A numerical optimization of the likelihood function multiplied by the
prior is used to obtain posterior modes. I then use a Metropolis-Hastings algorithm to generate a
sample and approximate posterior distributions. I use the DYNARE toolbox for MATLAB.
3.2
Data
I estimate the DSGE model over the period of 2002:q1 - 2009:q3 using …ve macroeconomic variables for
the Turkish economy. These variables are real GDP, GDP de‡ator, nominal interest rates, government
spending to GDP ratio and tax to GDP ratio. All the data are at quarterly frequencies. The data
series on log of real GDP is detrended, demeaned and seasonally adjusted. The others are demeaned
and seasonally adjusted where needed. Real GDP, GDP de‡ator and nominal interest rate series are
obtained from the data delivery system of the Central Bank of Turkey.15 Fiscal variables are obtained
from Public Accounts Bulletins of Ministry of Finance of Turkey.16
I use the overnight interbank money market interest rates (simple, annual), which closely follows
the policy rates targeted by the Central Bank of Turkey, and is very close to the interest rate on threemonths government bonds. The annual home in‡ation rate in each quarter is calculated by taking
into account the percentage change in the GDP de‡ator. Because the Turkish quarterly Public Sector
Borrowing Requirement (PSBR) data are unavailable17 , we use the central government expenditures,
excluding interest payments, and central government tax revenues as a proxy for …scal stance.18
3.3
Choice of Prior
We specify prior distributions for each parameter as reported in Table 1. Parameters with compact
support are assumed to follow beta distributions, parameters with restrictions on sign follow inverse
gamma distributions and we use normal and gamma distributions for the remaining parameters.
When deciding on prior means and standard deviations, we take into account that choosing a wide
(concentrated) prior distribution for a parameter shows that we have low (great) con…dence in prior
15
http://evds.tcmb.gov.tr/yeni/cbt-uk.html
See http://www.muhasebat.gov.tr/mbulten/2006_7meryone.php
17
PSBR covers central government budget, state economic enterprises, social security organizations, revolving funds,
unemployment insurance fund, local administrations and other funds.
18
Turkey has started to publish monthly data on central government budget, which covers the general budget, the
special budget and the regularity and supervisory institutions budget, since January 2006. Ministry of Finance of Turkey
also published yearly data for the central government budget for the period of 2000 - 2005. In order to obtain quarterly
data for the central government budget for the period of 2002 - 2005 we calculate the shares of quarterly primary
expenditures in total expenditures and the shares of quarterly taxes in total taxes for each year by using general budget
(on the base of 2007) …gures for 2004 and 2005 and consolidated budget (programme budget) …gures for 2002 and 2003.
Then, we apply these quarterly ratios to the corresponding yearly central government budget …gures in order to get
quarterly data.
16
8
information about that parameter. As in Lubik & Schorfheide (2007), it is assumed that all prior
distributions are independent.
Parameter
'
r
r
ry
g
gy
y
gb
b
a
y
a
y
r
g
Description
degree of price stickiness
inverse elasticity of labor supply
inverse elas. of subs. in cons.
degree of interest rate smoothing
Taylor rule coe¢ cient on in‡ation
Taylor rule coe¤. on output gap
degree of gov. spe. smoothing
spe. coe¤. on past output gap
degree of tax smoothing
tax coe¤. on past output gap
spending coe¢ cient on debt
tax coe¢ cient on debt
degree of backwardness
AR coe¢ cient of technology
AR coe¢ cient of world output
st. dev. of technology innovation
st. dev. of in‡ation innovation
st. dev. of world cons. innovation
st. dev. of interest rate innovation
st. dev. of gov. spe. innovation
st. dev. of tax innovation
Density
Beta
Normal
Normal
Beta
Gamma
Gamma
Beta
Normal
Beta
Normal
Normal
Normal
Beta
Beta
Beta
Inv gamma
Inv gamma
Inv gamma
Inv gamma
Inv gamma
Inv gamma
Mean
0.5
2.0
3.0
0.5
1.5
0.4
0.5
0.0
0.5
0.0
-0.03
0.03
0.7
0.8
0.8
1.0
0.6
5.0
0.4
2.0
1.0
St.error
0.1
0.5
0.75
0.2
0.5
0.2
0.15
0.05
0.15
0.05
0.02
0.01
0.1
0.1
0.1
4.0
4.0
4.0
4.0
4.0
4.0
Table 1: Prior Distributions
Some model paramaters were kept …xed in this study. For example, following the other studies in
the literature, discount factor, , is determined as 0.99 and so the annual steady-state real interest rate
is set to 4%. Following Lubik & Schorfheide (2007), the elasticity of substitution between foreign and
domestic goods
and elasticity of substitution between goods produced in di¤erent foreign countries
are calibrated as 1. Additionally, the degree of openness (import share), , is set to 0.27 by taking
into account the average value for import to GDP ratio in the period of 2002:q1 - 2009:q3. Similarly,
steady state value for private consumption to GDP ratio is set to 0.7 by taking into consideration
sample average of the estimation period. Finally, steady state value for domestic debt stock to annual
GDP ratio is assumed 0.37 by taking into account sample average of the period of 2002 - 2008.
Priors for the model parameters are generally chosen by taking into account the other studies
in the literature. The standard deviations of the structural shocks have inverse gamma distribution
with di¤erent prior means range between 0.4 to 5 and with a common degree of freedom equal to 4,
re‡ecting the fact that there is little prior information about these parameters.
I use fairly loose priors for the parameters of the monetary policy rule. Following Lubik &
Schorfheide (2007) I give a gamma distribution with mean 1.5 and standard error 0.5 for the pa-
9
rameter related to weight on in‡ation, r ; in the monetary reaction function.19 In a related study of
the Turkish economy, Ortiz et al (2009) selected relatively high prior mean as 2 and a very loose prior
standard error as 1.5 for Taylor rule coe¢ cient on in‡ation for Turkey for two di¤erent periods, 1989:q2
- 1993:q4 and 1989:q2 - 1998:q1. Setting the prior mean for the interest rate feedback on output gap,
ry ; to 0.4 with a prior standard deviation 0.2, allows the Central Bank to alter the interest rate only
weakly in response to output gap. Ortiz et al (2009) chose prior mean the output feedback 0.25 with
the same prior standard deviation 0.20. We chose the prior mean and standard error for the interest
rate smoothing parameter,
r;
as 0.5 and 0.2, respectively. Similarly, Lubik & Schorfheide (2007) and
Ortiz et al (2009) selected a prior mean as 0.5 and a prior standard deviation as 0.2 for Canada and
Turkey, respectively.
For …scal rules we chose prior mean as 0.50 and prior standard deviation as 0.15 for …scal smoothing
parameters,
g
and
, respectively. We chose zero prior mean with standard deviations as 0.05 for both
government spending and tax coe¢ cients on past output gap, gy and
y.
By centering the distribution
around zero we allow the data to tell us the direction of the …scal feedbacks on output gap (i.e. whether
or not …scal policy is contractionary or expansionary). Following Fragetta & Kirsanova (2010) small
values for prior means are used for …scal feedback parameters on debt stock (gb and
b ).
We use prior
means of -0.03 and 0.03 for feedback parameters on debt stock in government spending and tax rules,
respectively.20
We use beta distributions for the structural parameters in the hybrid Phillips Curve. The prior
mean of Calvo parameter (degree of price stickiness), , in the price setting equation was set to 0.5,
which implies that average length of a price contract is half a year.21 However, the standard error
allows for variation between 4 - 10 months. Since Turkey has experienced high and chronic in‡ation for
a long period, it is expected that …rms in Turkey try to modify their prices and wages more frequently
than …rms in developed countries. We use beta distribution with mean 0.7 and standard deviation 0.1
for the share of …rms which follow the rule of thumb price-setting rules. The same chronic in‡ation
can be a reason for strong past indexation.22
Following Fragetta & Kirsanova (2010) we choose 2 for the mean of the inverse elasticity of labor
supply, ', and 3 for the mean of the inverse elasticity of substitution in consumption,
errors are 0.5 for ' and 0.75 for
. Standard
.23
19
Lubik & Schorfheide (2007) chose 1.5 for prior mean and 0.5 for prior standard deviation for Taylor coe¢ cient on
CPI in‡ation for Canada in their benchmark speci…cation.
20
It has been shown in Kirsanova & Wren-Lewis (2007) that the optimal level of …scal feedback is small.
21
For example, Fragetta & Kirsanova (2010) selected the prior mean for Calvo parameter as 0.65 for the UK and the
US and 0.6 for Sweden. Smets & Wouters (2003) chose the mean of the Calvo parameters in the price and wage setting
equations as 0.75 for the Euro area, implying that average duration of the contract is one year.
22
See Kad¬o¼
glu (2006).
23
These prior means correspond to 0.5 for elasticity of labor supply (1=') and 0.33 for elasticity of substitution in
consumption (1= ). Lubik & Schorfheide (2007) and Ortiz et al (2009) chose 0.5 as a prior mean for elasticity of
substitution in consumption for Canada and Turkey, respectively. Fragetta & Kirsanova (2010) chose the prior mean for
; 3, 2.5 and 5 for the UK, Sweden and the US, respectively. On the other hand, they chose the prior mean for '; 3.5
10
4
Estimation Results
4.1
Parameter Estimates
Table 2 reports Bayesian estimates of the model parameters as point estimates of posterior means
with 90% con…dence intervals computed by Metropolis-Hastings sampling algorithm based on 100000
draws. According to multivariate and univariate diagnostics, a sample of 100000 draws was su¢ cent
to ensure convergence of the Metropolis-Hastings sampling algorithm. The estimation results are
generally consistent with the existence literature. All parameters are estimated to be signi…cantly
di¤erent from zero except the coe¢ cients of lagged output gap in the …scal policy rules. Moreover,
the data are informative as the posterior marginal densities of the parameters are generally more
concentrated than the prior marginal densities (Table 2, Figure 1)24 .
Focusing on the Taylor-type monetary policy reaction function reveals that the monetary authority
follows an active monetary policy (r = 1:75) in the sense of Leeper (1991) and demonstrates some
concerns for output gap (ry = 0:41). Ortiz et al (2009) found that the feedback parameter on in‡ation,
r ; is 1.19 and 1.77 for Turkey for the period 1989:q2 -1993:q4 and 1989:q2 -1998:q1, respectively. On
the other hand, they found smaller response of nominal interest rates to deviation of output from
its steady state value, ry , that was 0.17 and 0.20 for the …rst and second period described above,
respectively.25 The comparison of the priors and posteriors shows that feedback parameter on in‡ation,
r , is more concentrated, which re‡ects the fact that data is informative for this parameter (Table 2,
Figure 1).
The degree of interest rate smoothing is estimated as 0.62, which is in line with many studies.26
This estimate is higher than in Ortiz et al (2009) who estimate it 0.44 and 0.13 for periods 1989:q2 1993:q4 and 1989:q2 -1998:q1, respectively.
We also …nd a substantial …scal smoothing in both spending and tax rules. The degree of …scal
smoothing in government spending rule
g
= 0:59 is higher than that of tax rule (
= 0:48). Both of
them are statistically signi…cant and data is informative for these parameters (Table 2, Figure 1). On
the other hand, the coe¢ cients of lagged output gap in the tax and government spending policy rules
are estimated to be positive but statistically insigni…cant. The estimated value for …scal feedback
parameter in the government spending rule is negative and statistically signi…cant (gb =
0:035).
for the UK and Sweden and 2.5 for the US, respectively.
24
One may ask the close values between prior and posterior means for some parameters in the model. However, this
is a common …nding in this kind of DSGE models. See for example Fragetta & Kirsanova (2010).
25
Ortiz et al (2009) estimated monetary policy rule coe¢ cients by using DSGE model for many emerging market
countries. In this framework they estimated Taylor coe¢ cient on in‡ation as 0.71 for Brazil, 1.49 for Chile, 1.64 for
South Korea and 1.18 for Poland for di¤erent periods. They found average value for coe¢ cient on in‡ation and output
as 1.22 and 0.34, respectively for all developing countries which they took into consideration in their study.
26
Similarly, Lubik & Schorfheide (2007) also estimated a high degree of interest rate smoothing as 0.69 for Canada.
Lubik & Schorfheide (2005) also found a high degree of interest rate smoothing as 0.76 and 0.83 for the US and Euro
Area, respectively. Moreover, Fragetta & Kirsanova (2010) estimated a high degree of smoothing parameter 0.66, 0.75
and 0.61 for the UK, Sweden and the US.
11
STRUCTURAL PARAMETERS
8
0.8
0.4
4
6
0.2
ζ
θ
φ
σ
0.6
0.4
2
2
0.2
0
0
0
0
5
0
2
4
0
0.5
INTEREST RATE RULE
1
3
4
1
2
0
1
3
0
0
1
2
3
SPENDING RULE
0.5
1
20
8
1
g
ρ
g
y
b
6
g
2
0
0
1
1
0.5
0.5
0.5
r
π
r
ρ
2
0
y
1.5
r
6
0
0
4
4
10
2
0.5
0
-0.2
1
0
TAX RULE
0
-0.1
0.2
-0.05
0
0.05
0.04
0.06
10
5
τ
y
b
40
2
τ
ρ
t
3
1
0
0
0.5
1
0
-0.2
0
prior
0.2
20
0
Figure 1: Distributions of parameters
12
0.02
posterior
Parameter
Prior
Mean
0.5
2.0
3.0
0.5
1.5
0.4
0.5
0.0
0.5
0.0
-0.03
0.03
0.7
0.8
0.8
1.0
0.6
5.0
0.4
2.0
1.0
'
r
r
ry
g
gy
y
gb
b
a
y
a
y
r
g
Posterior
Mean
0.59
1.53
3.35
0.62
1.75
0.41
0.59
0.0
0.48
0.03
-0.035
0.023
0.83
0.79
0.90
1.02
0.66
6.39
0.32
2.13
0.83
Con…dence Interval
90%
0.43
0.74
0.78
2.26
2.24
4.39
0.50
0.74
1.28
2.28
0.15
0.67
0.33
0.85
-0.08
0.08
0.29
0.70
-0.05
0.10
-0.07
-0.0
0.01
0.04
0.75
0.92
0.65
0.95
0.85
0.96
0.33
1.65
0.48
0.82
3.02
11.15
0.12
0.49
1.66
2.54
0.66
1.0
Posterior
st. deviation
0.1
0.48
0.62
0.07
0.26
0.13
0.15
0.05
0.13
0.04
0.018
0.009
0.05
0.1
0.03
0.32
0.09
1.61
0.09
0.25
0.1
Prior
st.deviation
0.1
0.5
0.75
0.2
0.5
0.2
0.15
0.05
0.15
0.05
0.02
0.01
0.1
0.1
0.1
4.0
4.0
4.0
4.0
4.0
4.0
* Metropolis-Hastings sampling algorithm based on 100000 draws with 25.3% acception rate.
Estimated Equations:
n^ o
n ^ o
^
yt = E t y t+1
Et
g t+1 + ($
=
where
^
b^
H;t =
b
where
+ (1
+ ') y t
^
^
^
^
gt=
^
t=
)) ;
^n
(1
^
bt+1 =rt + 1 bt
rt =
Et
^
mct = (
^
)+ $
f
H;t 1 +
=
^
(1
^
g gt
^
H;t
^n
^
rt
r
1
1+ 1
t 1 + (1
rt
;$ =
n^
f
=
yt
+ (1
^
^
gt+ t
+ (1
)
r)
g
)
yt
r
^
1
1
yt
=
(1
Et
)(1 )(1 )
+ (1 (1 ))
^
C
^
gt
B
^
t
^n
H;t
+ ry y t
1
+ gb b t +
g
t
1
+
^
b bt
t
^
^n
^
rt
1)
)) ;
^
yt
^
y
c
yt +
t
^n
^
gy y t
^
(1
1
1) ct
+ (1
)(
o
^
H;t+1 + mct + t
+ (1
1
^
1) (
+
yt
^n
+rt +"rt
Table 2: Bayesian Estimation Results
13
n^
H;t+1
o
The data is informative as the posterior mean is di¤erent from the prior mean (Figure 1). The
…scal feedback parameter in the tax rule is positive (
b
= 0:023) and statistically signi…cant. As it
is expected, following an increase in the debt stock, taxes are raised and expenditures are reduced
in order to stabilise the debt stock. Overall, it might be interpreted that debt stabilisation is an
important motive in the conduct of …scal policy in Turkey (a passive …scal policy, in the sense of
Leeper (1991)).
Deep parameters of the Phillips curve, Calvo parameter (a degree of price stickiness),
backward looking parameter (the share of rule thumb price setters),
and
are estimated as 0.59 and
0.83, respectively (Table 2). Additionally, the prior and posterior distributions are di¤erent from each
other, which re‡ects the fact that data is informative for these parameters. The estimated value for
Calvo parameter, , implies that the prices are kept constant by …rms for less than three quarters in
Turkey. Price changes are more frequent in Turkey than in most developed countries but …rms are
likely to …x their prices for a short period in a volatile economy.27 The fraction
of the …rms ( = 0:83)
takes into account past in‡ation when setting prices, and the remaining fraction (1
= 0:17) prefer
to set prices optimally as in Calvo’s model. By combining the estimated values for
the …xed value for , we obtain the reduced form structural coe¢ cients, ;
Phillips curve. The implied values for
f
is 0.41 and for
b
is
0.5928
f
and
b,
and
with
in the hybrid
suggest that backward looking
behaviour remains predominant.29
The intertemporal elasticity of substitution in consumption (1= ) and the elasticity of labor supply
(1=') are found as 0.30 and 0.65, respectively. They are less than one and theoretically valid. The
data are informative for both these parameters.
Both autoregressive stochastic processes for technology and for the world output are found to be
highly persistent. As displayed in Table 2, AR coe¢ cient of technology ( a ) and of world output
are estimated 0.79 and 0.90,
y
respectively30 .
Overall, estimated parameters of policy rules are found to be similar to those reported in Gali and
Perotti (2003) in their asessment of monetary and …scal integration in Europe.
27
For example, Smets & Wouters (2003) estimated the coe¢ cient for as 0.90 for Eurozone. Another study, Fragetta &
Kirsanova (2010) found the value of Calvo parameter as 0.70, 0.64 and 0.78 for the UK, Sweden and the US, respectively.
28
Since the …xed value for discount factor is very close to 1 ( = 0:99) ; the sum of the values for the coe¢ cients of
lagged and expected future in‡ation is not equal to 1 but it is very close to 1.
29
Kad¬o¼
glu (2006) and Başkaya, Kara & Mutluer (2008) have a similar conclusion for Turkey. Kad¬o¼
glu (2006) …nds
that the coe¢ cients of lagged and future in‡ation are 0.82 and 0.18 respectively for the post-crisis period (2001:q2 2005:q4). She indicates that although a forward looking behaviour gained importance in Turkey with the implementation
of implicit in‡ation targeting regime in the period 2001 - 2005, a high degree of in‡ation inertia was also observed in the
same period because of Turkey’s past experience related to high and chronic in‡ation since 1970s and hence the existence
of strong past indexation behaviour in price determination.
30
Similarly, Fragetta & Kirsanova (2010) estimated AR coe¢ cient of technology 0.79, 0.76 and 0.81 for the UK, Sweden
and the US, respectively. They found AR coe¢ cient of world output around 0.90 for all countries.
14
4.2
Impulse Response Analysis
Figure 2 illustrates the results of impulse response analysis in terms of mean responses of observable
variables as well as unobservable debt stock together with 90% con…dence interval.
A positive tax shock reduces the output and increases the marginal cost and, thus, in‡ation (Figure
2). Following the increase in in‡ation, nominal interest rate is raised by the monetary authority. The
increase in taxes as well as in in‡ation lead to a reduction in the debt stock, this e¤ect outweighs the
e¤ect of higher nominal interest rates on debt. As a result of this, a tight …scal policy, introduced via
the increase in taxes, is accompanied by a tight monetary policy.
A positive spending shock leads to the increase of home in‡ation and output31 . Although an increase in government spending decreases in‡ation via marginal cost, the e¤ects of government spending
on marginal cost and hence on in‡ation are o¤set by the e¤ect of increase in output. This results
in higher in‡ation and the monetary authorities raise the interest rate. The increase in government
spending as well as the increase in nominal interest rates raises debt stock. In order to stabilise debt,
the government raises tax. As a result of this, an expansionary …scal policy via government spending
is accompanied by a tight monetary policy and by a tight …scal policy via taxes.
Following a cost push shock in‡ation raises, and in order to stabilise in‡ation nominal interest rate
is increased. Although the nominal interest rate remains high, the debt falls on impact due to the
bigger e¤ect of in‡ation. In order to bring both output and domestic debt stock back to their steady
state levels the government implements an expansionary …scal policy by decreasing tax and increasing
government spending. However, the responses of government spending, tax and debt are statistically
insigni…cant (Figure 2).
A positive shock to nominal interest rate lowers both in‡ation and output (Figure 2). The higher
level of interest rate also leads to the debt accumulation. In order to stabilise the debt stock the
government cuts the government expenditures and increases taxes. Lower government expenditures
and higher taxes also help to stabilise in‡ation by a¤ecting marginal costs of the …rms. This situation
can be summarised as follows: A tight monetary policy is followed by a tight …scal policy by means
of spending and tax.
World output shock (preference/taste/demand) leads to fall in both potential output and natural
level of the nominal interest rate. The decrease in natural level of interest rate also results in a decrease
in actual interest rates. Because of the lower nominal interest rates debt falls and so the governmet
increases spending and decreases taxes. An expansionary …scal policy also a¤ects marginal cost and
hence in‡ation. As a result of this, in‡ation falls and monetary authority keeps interest rates low in
order to reduce de‡ationary pressure.
31
As we mentioned in the previous paragraph, an increase in taxes directly a¤ects in‡ation via marginal cost. On the
other hand, government spending is a component of output and so an in increase (decrease) in government spending
directly increases (decreases) output via IS curve. Thus, an increase (decrease) in output also a¤ects in‡ation in the
same direction.
15
π
productivity
0.01
world output
0.5
y
0.05
1
0
0
20
0
-0.5
40 0
0
b
0.02
1
0
0
0
-0.01
0
τ
g
2
0
-0.02
20
-1
40 0
5
-0.02
20
-0.05
40 0
0.2
20
-0.04
40 0
0.1
-1
20
-2
40 0
2
20
40
20
40
20
40
20
40
20
40
20
40
0
-0.02
-0.5
0
0
0
mark up
-0.04
2
-1
40 0
1
1
0.5
0
20
0
monetary
-5
40 0
1
20
40 0
0.1
20
0
20
-0.5
40 0
0.5
20
-2
40 0
0.5
0
20
-0.1
40 0
0.02
20
0
0
20
-0.5
40 0
0.5
20
-1
40 0
2
-0.02
20
-0.04
40 0
4
1
0
20
20
-1
40 0
1
0.02
0.5
0
0
0
20
0.05
-0.5
40 0
0.04
20
-1
40 0
0.2
0
-2
40 0
0.2
20
0
0
20
20
-0.2
40 0
-0.5
40 0
1
20
-10
40 0
2
0.5
0
0
-2
0
0
-0.02
40 0
-0.5
40 0
20
10
0.02
20
20
0
0
0
-0.02
40 0
0.5
2
0
0
-0.05
-0.1
40 0
0.04
0
0.2
-0.2
-4
40 0
2
0
-1
-0.5
-0.1
20
1
0
0
-0.1
40 0
0.1
0
0
0.1
spending
20
-2
0
-1
tax
r
20
-0.2
40 0
20
-0.5
40 0
Figure 2: Impulse Response Analysis
16
20
-4
40 0
Following a positive productivity shock the natural level of output increases and natural level of
interest rate decreases. The decrease in natural interest rates causes the fall in actual interest rate. The
lower nominal interest rates also result in lower real interest rates, and this stimulates the economy.
Moreover, debt reduces following the decrease in nominal interest rates. The government responds to
the fall in debt stock with an expansionary …scal policy. This a¤ects the marginal cost of the …rms,
which leads to fall in in‡ation.
5
Conclusion
The interaction between monetary and …scal policy plays an important role for stabilising an economy.
The implementation of a sound …scal policy provides room for an active monetary policy. This paper
estimates a small scale New Keynesian open economy DSGE model for the Turkish economy using
a Bayesian estimation technique for the period of 2002:q1 - 2009:q3. We investigate the interactions
between monetary policy and …scal policy, and assess their stabilisation role. The main focus of the
analysis is the form and the strength of policy feedback rules. We estimate some deep structural
parameters of the model but we keep the model small-scale. Essentially it serves as a data generating
process to identify policy reactions.
The …ndings of the paper are consistent with the suggestions of the related literature. Moreover,
we …nd that the values of structural and policy parameters are generally consistent with those found
for most developed countries. The parameter estimates show that the monetary authority reacts to
in‡ation in an active way and only weakly responds to the output gap. The di¤erence between prior
and posterior distributions demonstrates that data is informative for most policy parameters. We
also …nd signi…cant …scal policy feedbacks on debt for both spending and tax rules. We show that
…scal policy has contributed to the debt stabilization but we did not …nd any evidence on active
stabilization of output gap by …scal means. Estimation results of the Phillips curve reveals that past
and expected future in‡ations are key factors in determining current in‡ation and backward looking
behaviour remains predominant. Despite successful disin‡ationary attempts, the in‡ation in Turkey
still has some degree of persistence.
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Central Bank of the Republic of Turkey
Recent Working Papers
The complete list of Working Paper series can be found at Bank’s website
(http://www.tcmb.gov.tr).
Productivity and Wage Differentials between Private and Public Sector in the Developing Countries
(Arzu Yavuz Working Paper No. 11/03, January 2011)
Cross-Country Growth Empirics and Model Uncertainty: An Overview
(Bülent Ulaşan Working Paper No. 11/02, January 2011)
Augmented Neoclassical Growth Model: A Replication over the 1960-2000 Period
(Bülent Ulaşan Working Paper No. 11/01, January 2011)
A New Core Inflation Indicator for Turkey
(Necat Tekatlı Working Paper No. 10/19, October 2010)
A Bayesian Generalized Factor Model with Comparative Analysis
(Necat Tekatlı Working Paper No. 10/18, October 2010)
Measuring the Impact of Monetary Policy on Asset Prices in Turkey
(Murat Duran, Gülserim Özcan, Pınar Özlü, Deren Ünalmış Working Paper No. 10/17, September 2010)
The Trade Credit Channel of Monetary Policy Transmission: Evidence from Non-financial Firms in Turkey
(Pınar Özlü, Cihan Yalçın Working Paper No. 10/16, September 2010)
Economic Uncertanity and Money Demand Stability in Turkey
(K. Azim Özdemir, Mesut Saygılı Working Paper No. 10/15, August 2010)
Effects of Monetary Unions on Inequalities
(Timur Hülagü, Devrim Ikizler Working Paper No. 10/14, August 2010)
Understanding Sectoral Growth Cycles and the Impact of Monetary Policy in the Turkish Manufacturing Industry
(Saygın Şahinöz, Evren Erdoğan Coşar Working Paper No. 10/13, July 2010)
Türkiye İçin Yeni Reel Efektif Döviz Kuru Endeksleri
(Hülya Saygılı, Mesut Saygılı, Gökhan Yılmaz Çalışma Tebliğ No. 10/12, Temmuz 2010)
Türkiye’de Piyasa Göstergelerinden Para Politikası Beklentilerinin Ölçülmesi
(Harun Alp, Hakan Kara, Gürsu Keleş, Refet Gürkaynak Musa Orak Çalışma Tebliğ No. 10/11, Haziran 2010)
Organization of Innovation and Capital Markets
(Cüneyt Orman Working Paper No. 10/10, May 2010)
Welfare Gains from Disinflation in an Economy With Currency Substitution
(H. Murat Özbilgin Working Paper No. 10/09, May 2010)
Interest Rates and Real Business Cycles in Emerging Markets
(S. Tolga Tiryaki Working Paper No. 10/08, May 2010)
Employment and Output Dynamics in a Model with Social Interactions in Labor Supply
(Yusuf Soner Başkaya, Mustafa Kılınç Working Paper No. 10/07, May 2010)