Testing the equilibrium path of exchange rates, monetary policy, and trade balance in the Türkiye

Abstract In this study, we examine the impulse responses of the trade balance to real exchange rates, national income, relative prices, and relative policy interest rate shocks in Türkiye between 2000-Q1 and 2024-Q2. Our empirical findings reveal that contractionary monetary policy improves the trade balance. In addition, these policies reduce national income, create an appreciation in the real exchange rate, and stabilize relative prices; in this respect, our findings are consistent with traditional neo-Keynesian synthesis macroeconomic theories. However, contrary to traditional theory, it is observed that increases in real exchange rates and relative prices do not create the expected improvement effects on the trade balance. However, in the case of Türkiye, it has been observed that increases in exchange rates and fluctuations in relative prices do not create the expected effect on foreign trade. In this context, our study provides evidence that monetary policies are effective tools for the trade balance, exchange rate, national income, and relative prices in Türkiye. In this respect, the effect of real exchange rates and relative prices on trade balance mechanism is theoretically insignificant. The study reveals that monetary policies in Turkey are more effective on the trade balance through the income channel. In other words, monetary policies shape the trade balance through impact with national income. While contractionary monetary policies reduce national income, local demand and production also decrease, which limits import demand. As a result, domestic demand shrinks, the foreign trade deficit decreases, and the trade balance improves. However, the effect of changes in exchange rates and relative prices on the trade balance is limited, which shows that foreign trade of Türkiye is largely dependent on income levels and domestic economic dynamics. From a broader perspective, our study finds evidence monetary shocks affect the trade balance mechanism mostly through income channel transmission but are not supported price channel mechanism narrative.