CURRENCY SUBSTITUTION AND EXCHANGE-RATE INSTABILITY - THE TURKISH CASE

In this paper we present evidence for the extent of currency substitut ion and its effects on exchange rate instability in Turkey. Following the capital account liberalization in 1987, the private sector has res ponded to the failed stabilization efforts of successive Governments b y requesting higher real interest rates on Government debt and by incr easing its holdings of foreign exchange at the expense of domestic cur rency. Theoretical models of exchange rate determination indicate that exchange rate instability increases with the degree of currency subst itution. We use an exponential GARCH (E-GARCH) model for exchange rate depreciation and find evidence in support of this hypothesis. Further more we test for the extent of currency substitution in determining sh ort-run dynamics of real money balances utilizing the expected depreci ation series obtained from the E-GARCH model. (C) 1997 Elsevier Scienc e B.V.