JURNAL (SOFTSKILL EKONOMI KOPERASI)

International Journal of Economics and Financial Issues

Vol. 3, No. 4, 2013, pp.874-884

ISSN: 2146-4138

www.econjournals.com

The Interest Rate Channel in Turkey:

An Investigation with Kalman Filter Approach

Taha Bahadır Sarac

Department of Economics,

Faculty of Economics and Administrative Sciences,

Nigde University, Turkey. Email: tbsarac@nigde.edu.tr

Okyay Ucan

Department of Economics,

Faculty of Economics and Administrative Sciences,

Nigde University, Turkey. Email: okyayu@hotmail.com

ABSTRACT: The monetary authority affects the aggregate demand and investment expenditure via controlling short run interest rates. It is important to satisfy the price stability together with working interest rate channel. This study aims to investigate the validity of interest rate channel in Turkey since the inflation targeting period starting with the year 2002. The sample period covers quarterly data from 1990:1 to 2011:3. It is stated that after the 2002 efficiency of interest rate channel increases.

Keywords: Kalman Filter; Markov Switching; Monetary Policy; Turkey

JEL Classifications: C32; C34; E52

1.      Introduction

The economy policies generally are divided into monetary policy and fiscal policy. While fiscal

policy uses the government expenditures and taxes as the instruments, monetary policy uses money supply, short term interest rate, discount rate and etc. However, there are differences of opinion among the economists, i.e,which one is more effective on the economic activity level. Classical economics that is the dominant economic thought up to the Great Depression emhasizes that there is no need any government intervention and economies are in balance. Moreover, any disequilibrium is equalized by the wages and flexible prices.

Following by the classical economic thought, the dominant one is the Keynesian thought in which economies with underemployment are in equilibrium. Keynesian thought stresses that fiscal policy is more effective than monetary policy due to the liquidity trap and zero sensitivity of investment to the interest rates. In the beginning of 1960’s monetary thought come on the scene and express that money supply has a fundamental role on determining the economic performance.

If we look over the Turkish economy, up to the 2000 it is seen that monetary pociy is restricted over against expansionary fiscal policy. However folowing by the economic crisis in the 2001, as part of the inflation targeting significant progress toward increasing the independence of executing the monetary policy of central bank has made. In this context, inhibiting the treasury from borrowing short term funds from central bank may be thought as an important development. It indicates that the macroeconomic stability is satisfied both by performing the structural reform and insisting on fiscal discipline together with increasing the applicability of inflation targeting regime. As a result of this macroeconomic stability, it emphasizes that efficiency of central bank gradually increases. So, contrary to the 1990’s central bank is more effective for achieving the price stability by using monetary transmission mechanism during this inflation targeting period. Monetary transmission mechanisms that covers the effect of monetary policy to the real macroeconomic variables, such as aggregate supply, unemployment and inflation have been examined through interest rate channel, exchange rate channel, bank credit channel and equity price channel. Beside this, it may be examined

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The Interest Rate Channel in Turkey: An Investigation with Kalman Filter Approach

by dividing into two channels so called interest rate and bank credit channels. Following by an expansionary monetary policy, interest rate falls and this causes a rise in investment and GDP at the interest rate channel. At the bank credit side, an expansionary monetary policy increases the the bank reserves and bank deposits together with a rise in quantity of bank loans available. Therefore, this increase will cause investment spending to rise, leading an increase in GDP.

In this study we aim to test the validty of interest rate channel for Turkish economy. Although there are huge number of study dealing with this, most of them use causality tests to validate the monetary transmission mechanisms. However, causality test does not allow to observe the trend of monetary transmission mechanism along the whole time period.

At the interest rate channel known as traditional Keynesian monetary transmission mechanism, effects of interest rate to the the economy are founded on the money market views of Keynes. Keynesian model emphasizes that equilibrium interest rate is determined by money demand and money supply. That is why, interest rate level can be adjusted by monetary policy leading to an increase in investment. However, at the interest rate channel it is stated that a fall in the interest rate causes a rise not only in investment but also in consumption expenditure. The sticky price assumption looms large in this channel. As to this, following by a fall in the short run nominal interest rates, lower interest rates then lead to decrease in short run real interest rates. According to the rational expectation theory, it is agreed that long term real interest rates will be the average of the expected short term interest rates. Therefore, as seen in Figure 1, this fall in long term real interest rates affect the firms’s investment and consumption expenditure (Mishkin, 1995; Kutter and Mosser; 2002).

Figure 1. Interest Rate Channel

						Increase in
						Investment
Money		A fall in		A fall in		Expenditure
								Aggregate
Supply Rise		short term		long term
								Demand
		real interest		real interest
		rates		rates		Increase in		Rise
						Consumption
						Expenditure

The purpose of this paper is to contribute to the existing literature by analysing the monetary transmission mechanism by using Markov-Switching method and Kalman Filter that allows to observe the effect of inflation targeting regime on interest rate channel in the given period. The paper is organized as follows. Section 1 discusses the theory. Section 2 summarizes the literature. The econometric methods and analysis are presented in Section 3. The overall conclusions are in the final section.

2. Literature Review

Following by Friedman and Schwartz (1963) who denote money supply affecting the real economy, most of the economist agree that monetary policies affect the real economy at least in the short run. However there is no consensus how monetary policy affect the real economy. Thus, there are lots of study resulting several conclusions about monetary transmission mechanisms so called “black box” (Bernanke ve Gertler, 1995, 1). Table 1 presents the summary of this literature review about interest rate channel.

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International Journal of Economics and Financial Issues, Vol. 3, No. 4, 2013, pp.874-884

Table 1. Literature review of related works

Author(s)

Countries and

Method

Results

Period

Taylor

Selected OECD

VAR

Interest rate elasticity of investment decreases

Countries

and interest rate

eleasticity of

consumption

(1995)

Analysis

(1970-1995)

decreases especially in USA.

Butzen et al.

Belgium

Panel Data

The contractionary monetary policy causes a

(2001)

(1985-1998)

Analysis

fall in firm profit.

Selected

A temporary rise in nominal and real short run

Peersman and Smets

European

VAR

interest rate, cause a temporary fall in output

(2001)

Countries

Analysis

level.

(1980-1998)

Selected

Angeloni

European

VAR

An unexpected short run interest rate causes a

et al. (2002)

Countries

Analysis

fall in output level after a year.

(1971-2000)

Sellon

USA

Graphical

The changes in financial system cause a rise in

(2002)

(1972-2000)

Analysis

efficiency of monetary policy.

Çiçek

Turkey

VAR

After

a contractionary monetary

policy, real

production decreases and this will be through

(2005)

(1995:1-2003:2)

Analysis

in two quarter terms.

General

The efficiency of interest rates on consumption

Zhang and Sun

is limited

without credit sector.

Therefore,

China

Equilibrium

(2006)

credit sector develops the efficiency of interest

Analysis

rate channel will rise.

Iwata and Wu

Non-linear

When

nominal

interest

rate  is

zero

level,

Japan

Structural VAR

monetary

policy

shock

affects

the

real

(2006)

Analysis

economy.

China

Granger

There

is

no

causality  neither  between

Yue and Zhou

investment expenditure and the market interest

(1996:01-

Causality

(2007)

rate nor between household consumption and

2005:08)

Test

the market interest rate.

Erdem et al.

Turkey

Kalman Filter

A rise in interest rates cause a fall in output

(2007)

(1989:1-2005:2)

Approach

deficit.

Selected

Papadamou

European

VAR

The interest rates

are efficient on industrial

and Oikonomou

Countries

production

index and interest

rate channel

Analysis

(2007)

(1996:04-

works.

2004:04)

Aktaş et al.

Turkey

Regression

The interest rate channel is efficient via market

(2001:07-

(2008)

Analysis

interest rates.

2008:08)

Büyükakın

Turkey

A change in interest rates attracts investment,

et al.

(1990:01-

Causality Tests

price level and output.

(2009)

2007:09)

Demary

10 OECD

VAR

A rise in interest rates cause a fall in output

Countries

(2010)

Analysis

level.

(1970:1-2005:4)

Marius and Angela

Romania

Graphical

After

the

2000,

efficiency  of

interest

rate

channel has risen via structural reforms in the

(2010)

(2000-2009)

Analysis

economy especially banking sector.

Sun et al.

China

VAR

GDP has decreased over against a unit shock

(2010)

(1996:1-2008:1)

Analysis

of repo rate.

Erdoğan and Yıldırım

Turkey

VAR

Interest rate channel did not work before the

(1995:01-

(2010)

Analysis

2002, however it has worked after the 2002.

2008:09)

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The Interest Rate Channel in Turkey: An Investigation with Kalman Filter Approach

			Following by the reform of banking sector,
Abdel-Baki	Egypt	Structural VAR	efficiency of the interest rate channel rises. In
(2010)	(1991-2009)	Analysis	addition to this, exchange rate is an another
			important variable at this point.
Claus	New Zelland	General	The effects of shocks will be higher without
	(only one quarter	Equilibrium
(2011)			using interest rate channel.
	data is used)	Analysis
Mukherjee and	Selected MENA	Panel Data	The consumption and investment expenditure
Bhattacharya	Countries
		Analysis	are sensitive to interest rates.
(2011)	(1990-2009)

3. Econometric Analysis

This part is divided into two sections. First one is econometric method and second one is econometric analysis.

3.1 Method

3.1.1 Markov Switching Model

Markov Switching models were introduced in econometrics by Goldfeld and Quant (1973). Regime switching models are regarded as a promising way to capture nonlinearities in time series. That is mostly true for Markov Switching model in which the probabilities of switching from one regime to another are assumed to be constant in the next period (Maddala& Kim, 1998, 455).

Expansion and recession periods are estimated as to state variable, s_t , that is defined directly

and  randomly.	In  regime	switching  models,  st    is  assumed	to  take	integer  values,  i.e.
st = {1, 2,....N	} . As to  N	state Markov chain, current regime	st  depends	only the st -1 . This

implication is given by Equation (1).

P

{

s = j /

s

= i , s

t -2

= k , .... = P

{

s

= j / s

= i

= p

(1)

where { pij }

t

t -1

}

t

t -1

}

ij

gives the state transition probability. Thus, pij

shows the probability of state i

i , j =1,2,...N

following by state

j and total probabilities are equal to 1 as seen in Equation (2).

pi1 + pi 2 + .... + piN = 1

(2)

The representation of all probabilities in

N ´ N matrix is given in Equation (3).

é p11

p 21

...

pN1

ù

ê

ú

N

P = ê p12

p 22

...

pN 2

ú ,

å pij

= 1,  i

= 1,2,..., N ,

0 £ pij £ 1

(3)

ê

...

ú

j=1

ê

p 2 N

....

ú

ë p1 N

PNN û

For the two state case, we have:

ˆ

é P ( st

= 1

t -1

) ù

t -1

= ê

ú

(4)

t

êP ( st

= 2

t -1

)ú

where

= {

, y

} .If ˆ

is known the regime for t

ë

û

t

t -1

t-1

may be estimated by the given information

t

t-1

at t -1. As to Equation (4) probabilities of

yt conditional on st and  t -1  as a collection in a (2x1)

vector are given in Equation (5).

é f ( yt

st

= 1,  t-1 ) ù

t

= ê

st

ú

(5)

ê f ( yt

= 2,  t -1 )ú

ë

û

The joint probability of yt and st is given by the Equation (6).

f ( yt , st

=  j

t -1 ) =

f ( yt

st

= j ,  t -1 ) P ( st = j

t -1 ) ,   j = 1,2

(6)

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International Journal of Economics and Financial Issues, Vol. 3, No. 4, 2013, pp.874-884

For the two state case, Equation (6) leads to Equation (7). The output ^ˆ_{t t} is calculated by manipulating ^ˆ_{t-1 t-1} (Hamilton, 1994).

2			2
f ( yt		t -1 ) = å å f ( yt			st ,  t -1 )P ( st		¢ ˆ	(7)
							t -1 ) =    t / t -1

s_t =1 s_t-1 =1

3.1.2 Kalman Filter Method

Kalman filter method based on the estimation of state- space models is defined with the following

equations in which Yt	is dependent variable and	Xt  is the explanatory variable.
		Yt =  t +  t X t		+  t	t = 1,2,...., N	(8)
		t	=  t -1	+ nt		(9)
		t	=  t -1	+ vt		(10)
where   t is constant,	t  is the coefficient of	explanatory variable and  t , nt  and vt				are the error
terms. Equation (8) represents the observation		(or measurement) equation, Equation (9) and (10)
represent the state	(or transition) equation. This system of equations are given in vector form with

Equation (11) and Equation (12) as observation and state equations respectively. The transition equation describes the dynamics of the coefficient Z_t , which is assumed to follow a random walk process.

Yt	=  ¢Zt	+  t	(11)
Z t	= AZ t -1 + wt		(12)
where Zt  is the time varying parameters imply ( t ,  t ) ,		implies constant term vector and  A

implies identity matrix,  _t  and w_t  are independent error terms. They are assumed to be independent

white noise processes. Here, coefficients can change over time and this model allows parameter estimates to respond differently under alternative policy regimes. The model takes into account for the Lucas (1976), Engle and Watson (1987) and Hatemi-J (2002) critiques. As to Lucas (1976), in the policy regimes macroeconomic parameter estimates are not invariant to changes and thus such estimates may be useless for forecasting the impact of the policy changes. In addition changes in the unobservable components of economic variables such as expectations will cause structural change in the data generating process and model misspecification is another justification for using time-varying coefficient (TVC) models. The nonwhiteness of the estimated error terms from the misspecified model can be explained by the changing coefficient values in the TVC model (Hatemi-J and Irandoust, 2008, 620-621).

3.2 Econometric Analysis 3.2.1 Data

The sample period covers quarterly data from 1990:1 to 2011:3. The raw data has been collected from Central Bank of Republic of Turkey (CBRT) and International Financial Statistics (IFS) data bases.

3.2.2 Model

Following by Mukherjee ve Bhattacharya (2010), we agree to use the following models:

Model 1: (C /Y ) =  0 +  1 (r) +  2 (G /Y ) +  3 (DY ) +  4 (Cp /Y ) +  1		(13)
Model 2: (I p / Y ) =  0 +  6 (r) +  7 (G / Y ) +  8 (DY ) +  9 (Cp / Y ) +  2		(14)
where  0  and  0  are the constants, all  1 ,  2 ,.... q  regression coefficients and	1 ,  2	are the error
terms. In addition Table 2 presents the definition of variables.

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The Interest Rate Channel in Turkey: An Investigation with Kalman Filter Approach

			Table 2. Variables and Definitions
Variables			Definitions
(C / Y )		:	The ratio of private consumption expenditures over GDP
(G / Y )		:	The ratio of government consumption expenditures over GDP
(C p	/ Y )	:	The ratio of aggregate private sector credits over GDP
(I p	/ Y )	:	The ratio of private investment expenditure over GDP
(DY )		:	Percentage change of the real GDP
(DINF )		:	Percentage change of consumer price index
(r )		:	Interbank interest rate

1)  Inflation is only used in Markov Switching Method.

2)  The variables except interest rate are seasonally adjusted by Tramo-Seats method.

3)  Inflation rate data covers from 1988:1 to 2011:4.

3.2.3 Results

3.2.3.1 Unit Root Test

Lee and Strazicich (2003) unit root test results are presented in Table 3. According to the unit root test results, we have found that (C / Y ) , (C _p / Y ) , (I _p / Y ) and (DY ) series are stationary in first differences and other series are stationary in levels.

Table 3. Lee-Strazicich Unit Root Test Results

Series			t-stats		Break Points
					First Break Points	Second Break Points
(C / Y )		-5.50 (3)		-11.89 (0)*	1994:2	2007:2
					2005:3*	2006:4*
(G / Y )			-6.64 (0)		1994:3	2000:1
(C p	/ Y )	-5.51 (7)		-9.59 (0)*	2000:1	2005:4
					2001:1*	2007:1*
(I p	/ Y )	-4.84 (7)		-6.76 (3)*	2000:3	2005:4
					1997:4*	2007:3*
(DY )		-4.32 (8)		-9.49 (3)*	2003:1	2007:4
					1993:3*	1999:2*
(DINF )			-8.78 (0)		1993:2	2002:1
(r )			-8.92 (1)		1994:3	2001:2

1)  The values within parentheses represent optimal lag lengths for autocorrelation.

2)   Critical values at .05 significance level for Lee&Strazicich test are taken from Lee and Strazicich (2003, 1084) for Model C and they are -5.59, -5.74, -5.67,-5.71,-5,65,-5,73 respectively.

3)  (*) indicates the t-stats and break points in first diffrences.

3.2.3.2 Markov Regime Switching Method

Markov regime switching method is used to investigate the efficiency of monetary policy interest rate channel in the different inflation periods. Graph 1 presents the estimation results of two regime so called contraction and expansion periods.

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International Journal of Economics and Financial Issues, Vol. 3, No. 4, 2013, pp.874-884

Graph 1. Markov Regime Switching Method Results

ProbabilitiesProbablitiesofContractionractionofRegimeReji (filteredd) )

1.00
0.75
0.50
0.25
1990	1995	2000	2005	2010
1.00
0.75
0.50
0.25

1990     1995     2000     2005     2010

Probablities of Contraction Rejime (smoothed)

Probabilities of Contraction Regime (smoothed)

Probabilities of Expansion Regime (filtered)

Probabities of Expansion Regime (filtered)

1.00
0.75
0.50
0.25
1990	1995	2000	2005	2010

1.00

0.75

0.50

0.25

1990	1995	2000	2005	2010
	Probabilities of Expansion Regime (smoothed)
Probabilities of Expansion			Regime (smoothed)

According to the results in Graph 1, probabilities, number of observations corresponding to the related periods are presented in Table 4.

Table 4. Regime Properties and Transition Matrix

Transition Matrix

Regime		Contraction			Expansion
Contraction		0.50125				0.12820
Expansion		0.49875				0.87180
			Regime Properties
Regime	Number of		Periods		Average		Average
	Observations				Probabilities		Durations
	13		1988:1 - 1991:1		0.813
Contraction	2		1992:2 – 1992:3		0.630		9.40 quarter
	2		2002:2 – 2002:3		0.590
	26		2003:3 – 2009:4		0.894
	4		2010:2 – 2011:1		0.795
	4		1991:2 – 1992:1		0.917
Expansion	38		1992:4 – 2002:1		0.965		9.80 quarter
	3		2002:4 – 2003:2		0.613
	1		2010:1 – 2010:1		0.745
	3		2011:2 – 2011:4		0.864

Linearity LR-test Chi^2(4) =  43.518 (0.0000)* approximate upperbound: (0.0000)*

Note: The likelihood ratio (LR) test implementing the upper bound of Davies (1987) also suggests that all models reject the null of linearity at the .01, .05 and .10 significance levels and certify the use of regime-switching models.

880

The Interest Rate Channel in Turkey: An Investigation with Kalman Filter Approach

Table 4 shows that after the inflation targeting regime probabilities of contraction increase also during (2003:3-2009:4) period. This result also indicates that monetary policy is efficient to control high inflation most of inflation targeting period which starts at January 2002.

3.2.3.2 Kalman Filter Method

Kalman Filter Method needs stationary variables so variables used in the analysis are all stationary. Here crisis dummies are d1, d2 and d3 are for the years 1994, 2001 and 2008 respectively. Kalman filter method is used to determine the paramaters which are chanching over the time. And we also expect that interest channel is more efficient during the inflation targeting regime. In other words, the values of the ₁ and ₆ is becoming high after the inflation targeting regime is adopted by the

Central Bank of Turkey. So we have performed the Kalman Filter method, and showed the results in Graph 2 and 3.

Graph 2. Kalman Filter Method Results (Model 1)

.15
.10
.05
.00
-.05
-.10
-.15
92	94	96	98	00	02	04	06	08	10

6
4
2
0
-2
-4
92	94	96	98	00	02	04	06	08	10

 Interest Rate Parameter  ± 2 RMSE

.2

.1

.0

-.1

-.2

-.3

92   94   96   98   00   02   04   06   08   10

 Economic Growth Parameter

 ± 2 RMSE

 (G/Y) Parameter  ± 2 RMSE

100

50

0

-50

-100

-150

92   94   96   98   00   02   04   06   08   10

 (Cp/Y) Parameter  ± 2 RMSE

When we analyze Kalman Filter method results, we have seen that interest rate effects consumption and investment expenditures negatively. Especially, as can be seen in Graph 3, the effect of interest rate on consumption expenditures undergone a sharp change during inflation targeting period.

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International Journal of Economics and Financial Issues, Vol. 3, No. 4, 2013, pp.874-884

						Graph. 3 Kalman Filter Method Results (Model 2)
.08										2
.04										1
.00										0
										-1
-.04										-2
-.08										-3
-.12										-4
92	94	96	98	00	02	04	06	08	10	92	94	96	98	00	02	04	06	08	10

		Interest Rate Parameter	± 2 RMSE				(G/Y) Parameter	± 2 RMSE

.10
.05
.00
-.05
-.10
-.15
-.20
92	94	96	98	00	02	04	06	08	10

 Economic Growth Parameter

 ± 2 RMSE

80

40

0

-40

-80

92   94   96   98   00   02   04   06   08   10

 (Cp/Y) Parameter  ± 2 RMSE

4. Conclusions

While the Central Bank of Republic of Turkey implements implicit inflation targeting from 2002 to 2006, from 2006 to present explicit inflation targeting has been implemented. Following by the inflation targeting regime practice, it is observed that a noticeably decrease in the inflation level occurs. It is approximately 70.01 % and 11.6 % in the 1983-2001 and 2002-2011 periods respectively . This case indicates that inflation targeting regime is an effective monetary policy instrument. The efficient monetary policy means monetary transmission mechanism works well.

This study aims to investigate the economic influences of the inflation targeting regime on the interest rate channel. Results show that inflation targeting regime is effective not only on decreasing the inflation rates but also on increasing the performance of interest rate channel. In other words, Central Bank is effective on both consumption and investment expenditure in the inflation targeting regime period. Especially, it is stated that its ability on controlling the consumption expenditure increases.

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The Interest Rate Channel in Turkey: An Investigation with Kalman Filter Approach

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