I have recently watched an interesting video about Turkish economy given by an investment advisor. There may not be too many people paying attention to Turkey's economy. Yet, the story of this country in recent years has given an important macroeconomic lesson to the world: how someone don't understand macroeconomics but try to manipulate the economy can lead to a disaster.
Is macroeconomics useful? What if I say everything in the economy works well because people have used macroeconomics properly? If this is true, I guess you will agree that macroeconomics is important. But normally we can't prove this. When everything works well, no one knows what makes it work well. Only when things do not work well, and so people will try to find out what's wrong and fix it, they may be aware that something is important.
That's why the Turkey case is important. It exactly shows us how important macroeconomics is. It can guide us to figure out what's wrong with the Turkey economy and how can it be fixed.
What's wrong in Turkey? It's about high inflation. It's also about the misuse of solution - lowering interest rate.
According to the video, the president of Turkey, Recep Tayyip Erdoğan, has started criticized the high interest rate in Turkey since 2018. Eventually, since 2019 he urged the Turkey central banker to slash interest rate although inflation was very high at that time. The president said that interests add to the business cost, which in turn would cause firms to charge higher prices to products. As such, interest rate should be cut down instead of being raised.
Anyone knowing some economics should know that the president did exactly the contrary of what economists would suggest to cope with high inflation. Of course the economists' suggestion is also what is usually used in the real world (by central bankers) to cope with inflation problem.
Since you are now reading this article, I guess most likely you believe more in the economists' suggestion than the Erdogan's. But Erdogan's idea also seems to make some sense. Why can't he be right? What's the logic behind?
Before we discuss the logic. Let's see what have happened in Turkey. The central bank did lower interest rate from 24% to 12% in 2019 when inflation rate was as high as 16%. Thereafter, interest rate stayed at around 10 to 17% for years. Yet, inflation started to react aggressively in 2022, going up to 70 to 80% while the central bank chose to cut interest rate even more aggressively to 9%. The uncontrolled sky-high inflation rate in 2022 prompted Turkey central bank to yield and raised interest rate again. Interest rate since then stayed at 40% to 50% while inflation rate stayed at very high rate, despite not as high as 80%, but at 50 to 60%. Only since 2025, both interest rate and inflation rate had "slowed" to 30% to 40%.
Why did a lower interest rate worsen inflation in Turkey? The abovementioned video attributes the problem to exchange rate. A lower interest rate triggered a depreciation of the Turkish currency. As Turkey had to imported a lot. Depreciation pushed up imported prices and generated inflation. In 2018, less than 5 Turkish Lira could exchange for 1 US dollar. In 2019, you needed about 6 Lira. When inflation peaked at 70-80% in 2022, Lira dropped to 16-17 for 1 US dollar. Later, it continued to drop and now it is more than 40 Lira for 1 US dollar.
At this point, you have already been told two theories about Turkey macroeconomy in the said period: One is made by President Erdogan, who says lower interest rate can lower business cost and so lower price-inflation. Another is made by the video creator, who says a lower interest rate causes a depreciation in Turkish currency and so increases the imported prices as well as price-inflation.
Yet, both of them, I will say, won't be a standard answer given in the standard macroeconomics theory.
Erdogan considers interest rate as business cost. That's of course true. But when he attributed high inflation (or price level) to interest cost, he obviously considers only the supply-side factor in the economy. Furthermore, even regarding supply side, it is doubtful that a lower cost will induce firms to charge a lower price. When cost goes down, firms may keep the same price and enjoy a higher profit. Why should firms reduce prices? This depends on how competitive the market is. Does Turkey has a very competitive market such that firms will cut price to attract clients, or has a monopolistic market? I am not so sure. I have doubts. But that's more a microeconomic issue and so let me set it aside. Let me turn to macroeconomics.
If you are familiar with the macroeconomic approach, you will consider Erdogan's treatment of interest rate unusual as macroeconomics normally considers interest rate on the demand side, not on the supply side. When interest rate goes down, private investment will increase and so aggregate demand will increase. Why does demand increase? In macroeconomics, investment normally refers to capital investment such as buying new machines and building new factories. These new capital goods form part of the GDP. When investors buy them, demand for goods produced in a country increases.
But why not supply side? Erdogan is perhaps right in the long run: interest rate reduces business cost and so will increase supply. But normally the fruit of investment (capital investment) takes a longer time to bear. Investing in a machine can enhance production capacity. But it takes time for the machine to be produced. Even if it can be delivered shortly, the production process of most goods involve a long sequence. The capacity can't be expanded shortly. Therefore, the effect of low interest rate (if it stays low for long) will only be realized on the supply side in the long run, but its effect is immediate on the demand side (in so far as the capital goods are bought).
Well, in the short run, low interest rate stimulates demand but not supply, a higher price will result. Inflation may happen. Erdogan is not right.
Meanwhile, the video creator attributes high inflation to currency depreciation, which pushed up import prices. Is he right? Partly. Turkey Lira did depreciate a lot ever since Erdogan's interest rate-cut policy has been adopted. Why will currency be affected? On one hand, interest rate has long been considered as a key factor in determining the currency value. The point is: people may choose to withdraw money from Turkey as interest income from holding Turkey assets is lower relative to the income that comes from holding assets in foreign countries, and the risk involved in investment in Turkey. This reduces the demand for Turkish currency and so depresses its value. On the other hand, a more non-standard situation applies to Turkey. When its government adopts an unorthodox policy (cutting down interest rate when inflation is high), foreign investors may be scared off. They are accustomed to policies following theories that are usually considered to be sensible. They will suspect policies not following orthodox simply make things worse and worse. They will fear that something destructive may eventually happen to the country's economy. So, they may move their money from Turkey. This again depresses the currency value.
While the video creator's point of depreciation due to interest rate cuts is right, how he explains inflation is another matter. He said Turkey requires a lot of imported goods, which are essential for its economy. When its currency depreciates, imported prices went up and so was the inflation. This explanation is rather arithmetical. Basically it is about how the price index is calculated. When a large component of the price index is imported good, the higher price of the latter can obviously push up the former. But is thing so simple?
In macroeconomics, we will not attribute high inflation to such a simple arithmetic. Rather, we attribute it to factors in the demand and supply of the whole economy. In fact, when we turn to demand, import is actually a negative factor to the demand and GDP. Import is not about a demand for locally produced good. Rather, it is a demand for foreign products. An increase in it will reduce the demand for local goods and so GDP. Currency depreciation should normally reduce imports as it means Turkish has to pay more Lira to buy the same quantity of imported goods. If this happened, currency depreciation will decrease the demand and reduce inflation, not exaggerating it. Yet, this didn't happen during the period. There must be something unusual happening. One possible explanation is that Turkish might be, like the foreign investors, scared off by the unorthodox policy and worried that currency would go down further and so bought more imported goods before they became even more expensive. But anyway, this is not our main point. Our point is: we can't simply look at imports.
With currency depreciation, exports normally grow as foreigners find these goods cheaper. That's also what happened in Turkey. Turkey exports increased with currency deprecation. With both exports and imports increasing, what's the trade balance (export minus import)? In fact, Turkey trade balance worsen. The trade deficit (import minus export) expanded during the period.
What does it mean? It means demand decreased. It is the net export, or export minus import, that matters to the GDP, not simply imports. If demand decreased, this should reduce inflation in Turkey, not pushing it up. Why did such a thing not happened?
All these point to one thing: all these analyses must miss something important, which can dominate all the contradicting factors above and can explain the high inflation. In fact, it is not difficult to identify the factors, as normally, and you may already heard this before, economists attributes high inflation to excessive money supply.
When laymen learned that a central bank cut down the interest rate, they often think that all interest rates are controlled by the central bank, who can bring down all the interest rates by simply saying that they should come down. But obviously that won't be true. Bank interest rates are already numerous, and bond interest rates are also not directly controlled by any one single party, but by many parties trading bonds in the market. The central bank can normally control only a few interest rate directly, such as its lending rate to commercial banks (discount window rate). But if the central bank's decision to cut rate can truly have widespread effects on all different kinds of interest rates in the market, this must involve the central bank doing something more than cutting a specific interest rate (discount window rate).
That's what your macroeconomics told you already: the central bank can change the money supply and so affect interest rates in the market. To support Erdogan's low interest rate policy, Turkish central bank did expand the money supply dramatically. Meanwhile, when it eventually reversed the low interest rate policy, the central policy tightened the money supply significantly. It is interest rate following money supply, not the other way round.
If money supply grows very fast, aggregate demand also grows fast. Though trade deficit expansion should slow down demand growth, this could only moderate the demand growth when you talk about money supply growth of 50 to 60% a year. Hence, inflation will become high, very high (50 to 60%). In contrast, tightening money supply growth can slow down demand expansion and inflation. That's what happened.
These are the macroeconomics that you have learned and can explain what happened. Why few laymen use it?
In a way, the money supply explanation is not used because laymen may often confuse interest rate cut with money supply expansion. The central bank's announcement is so eye-catching while money supply change is so less noticed. As such, a laymen may be occupied fully by the eye-catching Erdogan policy of low interest rate, and can easily ignore the more complicated mechanism behind - money supply.
For another thing, attributing high inflation to currency depreciation and high imported goods can only explain some aspects of the issue, but can't explain the whole picture (why expanding trade deficit can't cool down inflation). In fact, in this case, import price (going up) went in the same direction of the general inflation (going up). Thus, it is convenient to pick up import price as an explanation for inflation. If there is no such a coincidence, people can't enjoy this convenience and will look for another explanation. Yet, there is such a coincidence and the explanation via import prices look so natural and understandable to laymen. That's why people may avoid thinking deeper and sort out what truly matters to the economy. We are all lazy and, if we can, we don't want to go through the troubles of thinking deeper.
Unfortunately, macroeconomics is not for lazy people.
