On the Link between Dollarization and Inflation: Evidence from Turkey*

Abstract

This paper investigates the role of dollarization in the dynamics of inflation in Turkey. Descriptive analysis suggests that, in addition to high inflation and economic instability, institutional factors also played an important role in the evolution of dollarization in Turkey. The empirical findings corroborate the importance of dollarization in the dynamics of inflation. The results suggest that shocks to dollarization initially lead to a decline in the monetary base as the public switches from domestic to foreign money holdings. However, the monetary base increases later on to generate the required inflation tax for a given budget deficit. The findings also indicate that the fiscal authority tries to compensate part of the decline in inflation tax through raising administered prices. As expected, the exchange rate responds positively to shocks to dollarization owing to the high elasticity of substitution between domestic and foreign currency.

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