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I.TABLE OF CONTENTS: I.TABLE OF CONTENTS:... 1 II-LIST OF ABBREVIATIONS... 3 III-LIST OF FIGURES... 4 IV-LIST OF TABLES... 5 V-ACKNOWLEDGEMENT... 6 VI-ÖZET:... 7 VII-ABSTRACT: INTRODUCTION: A BRIEF REVIEW OF THE LITERATURE ON THE MONETARY POLICY AND ASSET PRICE RELATIONS: The Taylor Rule: Specification of the Taylor Rule: Estimation Data: A Brief Information About Turkish Stock Market: The Credit Outlook of Turkey as an Investment Criteria: The Standart Taylor Rule: The Augmented Taylor Rule: Forward Looking Models and Generalized Method of Moments: Estimation of the Taylor Rule: Graphical Inspection of the Data: Standart Taylor Rule with Ordinary Least-Squares Method : The Wald Test: Visual Impression Regarding the Model: Chow Breakpoint Test: Estimating The Augmented Taylor Rule: Ordinary Least-Squares Analysis (ATR): Diagnostic- Normality Test: Diagnostic- Heteroskedasticity Test: Diagnostic- Breusch-Godfrey Serial Correlation LM Test: Ordinary Least Squares Analysis (Newey-West Option): Generalized Method of Moments(GMM) Estimator: CONCLUSION: REFERENCES II-LIST OF ABBREVIATIONS ATR: Augmented Taylor Rule BIST100: Borsa Istanbul 100 BIST30: Borsa Istanbul 30 CPI: Consumer Price Index DW: Durbin-Watson FED: Federal Reserve GDP: Gross Domestic Product GMM: Generalized Method of Moments IMKB: Istanbul Menkul Kıymetler Borsası OLS: Ordinary Least-Squares RGDP: Real Gross Domestic Product S&P: Standard and Poor s STR: Standard Taylor Rule UK: United Kingdom US: United States 1Q: First Quarter 4Q: Fourth Quarter 3 III-LIST OF FIGURES Figure 1. The Correlation Between The Interest Rate And Asset Prices Figure 2. Movements In Interest Rate Figure 4. Movements In Inflation Figure 3. Movements In GDP Figure 5. Movements In BIST100 4 IV-LIST OF TABLES Table 1. Ordinary Least-Squares Analysis (STR) Table 2. The Wald Test Table 3. Chow Breakpoint Test Table 4. Ordinary Least-Squares Analysis (ATR): Table 5. Jarque Bera Test: Table 6. Heteroskedasticity Test Table 7. Breusch-Godfrey Serial Correlation LM Test: Table 8. Ordinary Least Squares Analysis (Newey-West ) Table 9. Generalized Method of Moments(GMM) 5 V-ACKNOWLEDGEMENT This dissertation would not have been accomplished without financial support of EU Jean Monnet Scholarship Programme. I would like to acknowledge my debt to Mrs. Duygu Yardımcı, Project Coordinator of Scholarship Programme, and her colleagues for their technical support during my MSc study. 6 VI-ÖZET: Bu tezde para politikasının varlık fiyatlarındaki dalgalanmalara karşılık verdiği hipotezi araştırılacaktır.çalışmada yukarıda verilen hipotezin lehinde ve aleyhinde ileri sürülen argümanlar açıklanacak, hipotezin ampirik çerçevesi tartışılacak ve hipotez test edilecektir.araştırmada ampirik çerçeve olarak Taylor Kuralı kabul edilmiş ve bir sonuca ulaşabilmek adına bu kuralın standart ve genişletilmiş versiyonları kullanılmıştır.bu çalışmada özellikle araştırılan konu Türk hisse senedi piyasasında 1997 ve 2012 yılları arasında yaşanan dalgalanmaların para politikasının belirlenmesi konusunda doğrudan veya dolaylı olarak kritik bir rol oynayıp oynamadığı hususudur. 7 VII-ABSTRACT: In this dissertation, we investigate the hypothesis that monetary policy responds to movements in asset prices.in the study the arguments in favor and against the above hypothesis will be studied, the empirical framework will be discussed and the hypothesis will be tested. In the investigation, we adopt the Taylor rule as the empirical framework and used its standard and augmented versions in order to reach a conclusion.in this study, we will especially explore that whether the stock market movements play a crucial role in shaping monetary policy either directly or indirectly in Turkey between the years 1997 and 1-INTRODUCTION: Turkish economy showed an outstanding performance between the years of 1997 and 2012.During the period, the inflation rate dropped to %6.16 from %85 and parallel to the inflation rate interest rate dropped almost %60 while GDP rose almost %4 annually in average. Additionally BIST100, the stock market value of Turkey rose almost 60% in 2012 and reached the index level while it was only at index level at The objective of this investigation is to test the hypothesis that monetary policy responds to movements in asset prices. In this study, we will try to prove that there is a significant correlation between monetary policy and asset pricing.policy rules of central bank of Turkey and reflections of those decisions in the stock market between the period of 1997 and 2012 will be the main investigation subject of this study. According to Bernanke and Mihov (1998) the process by which the central banks control the money supply in order to keep the interest rate at certain levels for promoting economic growth and price stability is called monetary policy.the need to the central banks in providing a stable economic outlook has increased during the last years. So as a policy maker, central banks should struggle with inflation as well as they should prevent the markets from the financial crisis. Bernanke (2000) also claims that inflation is no longer a great issue to concern about since the world s leading central banks have been very successful at keeping it under control over the past twenty years. Nowadays an apparent increase in financial instability and increased volatility of asset prices seem to be the next battles facing central banks. According to Mishkin (2012) mismanagement of financial liberalization and asset-price booms and busts can trigger financial crises which usually results in failures of major financial institutions and increased uncertainty in the financial markets.when investor psychology affects the assets prices such as equity shares and real estate above their fundamental economic values, the rise of asset prices called as an asset-price bubble. Those bubbles in asset prices are often driven by credit booms which are usually supported by the policies of the central banks. 9 Allen and Gale (2000) argue that the recent financial crises which was caused by the bubble of asset prices is resulted with widespread defaults of some leading financial institutions. The money borrowed from banks for asset investment is always attractive for investors who plan to default on the loan rather than making safe but small amounts of profit in their investments. At the times of financial fragility, the risk appetite of the investors in both the real and financial sectors investments can lead the asset prices to very high levels and cause crisis due to the insufficient positive credit expansion. There have been two major asset bubble crisis in 1929 and 1980 at the last century.both of them caused protracted recessions and deflation.according to Bordo and Jeanne (2002) The policy makers have a perennial interest in the relation of monetary policy and asset price movements since it is essential to decide whether trying to prevent the results of an asset market collapse before it turns to a financial crisis or whether it was more effective to react the asset prices after financial markets completely went down. Bean (2004) claims that in the aftermath of the recent crisis caused by asset price bubbles in Japan and U.S. the most popular debate between central bankers and academic circles was the role of the asset prices in the setting of monetary policy. Views of Gilchrist and Leahy (2002) remind the following period of increased volatility in asset prices in Japan and US.Then most of the economists had called for central banks to respond to asset price volatility against to large swings in growth rates. 2.A BRIEF REVIEW OF THE LITERATURE ON THE MONETARY POLICY AND ASSET PRICE RELATIONS: The role of asset price movements in shaping monetary policy can be explained by two opposite view in the literature. Some economist such as Bernanke and Gertler (2001) and Vickers (1999) claim that there is no need to believe in asset price volatility as a key determinant for setting monetary policy but on the other hand, Cecchetti, Genberg and Wadhwani (2002) believe volatility in asset prices can help central banks when shaping monetary policy by providing more information. According to Bernanke and Gertler (2001) the appropriate position of asset prices in the monetary policy has been witnessed to many debates. The question of whether central 10 banks should respond to volatility in asset prices or not can be answered by the inflation-targeting approach. According to this view volatility in asset prices may affect the monetary policy if only the expected inflation rate is affected negatively from those movements. For instance, a bubble in asset prices can increase the aggregate demand by increasing consumers wealth and affect the inflation negatively.furthermore, once the effects of asset prices in the general price level have been accounted for central banks should not response the changes in the asset prices anymore. This is a crucial point in monetary policy because this kind of attempts to influence asset prices can affect the investors psychology and lead the markets unpredictable future. According to Cecchetti et al. (2002), it is possible to improve macroeconomic performance by reacting to asset price misalignments systematically. Just by setting policy rates with an eye toward particularly in misalignments and generally in asset prices can help to smooth output and inflation fluctuations. Distortions in investment and consumption created by asset price bubbles can cause excessive increases followed by severe falls in both inflation and GDP. To raise interest rates when asset prices rise above the expected levels and to lower them modestly when asset prices fall below the reasonable levels will help central banks to offset the impact on inflation and output gap of these bubbles. The important outcome of this kind of monetary policy is to show the markets that central banks can take the necessary measurement in this way. The probability of bubbles in equity prices might be reduced and a contribution to greater macroeconomic stability would also be provided by this method. Bernanke and Gertler (2001), claim whether the volatility in asset prices is the result of bubbles or technological shocks, an aggressive inflation-targeting policy stabilizes output and inflation. In their opinion the study of Cecchetti et al. ignores the fact of shocks other than bubble shocks and the probabilistic nature of the bubble. Their theory lies on the assumption of a bubble shock which lasts precisely five periods. Also, the knowledge of the central banks about the reasons and the bursting moment of the bubbles are both highly unlikely conditions. A panic-driven financial instability that could affect the economy negatively can be reduced and macroeconomic stability can be sustained by inflation targeting monetary policy. In the end, they conclude for plausible parameter values the central banks should not respond to asset prices. 11 On the other hand, Cecchetti et al.(2002) claims that the underlying sources of shocks to the economy determines the relationship between fluctuations in asset prices on the one hand, and output and inflation on the other. So they suggest that monetary authority should not interfere to all changes in asset prices mechanically and in the same way. Since the private sector might possess more information about equilibrium valuations of asset prices, it would be possible to react anything from asset price fluctuations that can help to shape monetary policy. Cecchetti et al. (2002) also claims that not all asset price changes, but the asset price instability should be identified and responded in an inflation-targeting strategy. That means stock market value should be included in the information sets in order to be processed by the central bank just as well as the output gap. The problem of to differentiate the asset price movements and to realize whether they are justified by underlying fundamentals or not is the main challenge of the policymakers. 2.1.The Taylor Rule: As a major tool of monetary policy central banks should change the interest rate in order to provide macroeconomic stability first and then keep the employment in maximum levels.taylor rule which was proposed by world renowned monetary economist John B. Taylor and named after him can help central banks with the question of how much would it be the optimum interest rate. Taylor principle is a different aspect of taylor rule and stipulates that the nominal interest rate should be raise more than the increase in the inflation rate. According to Castro (2008) to set up the interest rate past or current values of inflation and output gap is a commonly used method by central banks.in its very original form, the main objectives of the Taylor rule are providing the price stability and keeping the economy moving towards maximum employment.in order to keep the general price level stable Taylor rule simply recommends that when the inflation rate is exceeded the target level central banks should rise the interest rate above the level of the stabilizing rate and when it is below the target level interest rate should be decreased to the levels below the target.in order to accomplish the second objective of the Taylor rule it is suggested that the interest rate should be determined above the stabilizing rate when real 12 GDP is above the target. If real GDP is below the potential real GDP Taylor, recommends that the interest rate should be reduced below the stabilizing rate. According to Taylor (1993) conducive monetary policy requires to put equal weights on the impact of inflation and GDP since putting more weight on the inflation gap could be a sign of more aggressive policy to target inflation by the central banks. Godhart and Hofmann (2000) believe that the question of how asset price volatility should be considered in principle for objectives of monetary policy is subject to a consensus among leading economists.an inflation target which can also be defined as achieving price stability is the primary objective of the central banks while inflation is a price index which consist of current goods and services but excludes assets prices directly. Frait and Komarek (2006) point out that asset price developments are usually taken into account when refining monetary policy, even if central banks formally targets price stability. The reason for this approach lies on the fact that asset price movements, especially physical assets, can impact on CPI inflation by tempting the people to invest in those assets.once people starts buying those assets the production of the assets rises as well as the demand for the raw materials and this cycle triggers the CPI inflation. Figure 1. The Correlation Between The Interest Rate And Asset Prices Furher and Tootell (2008) claim that there has been identification or observational equivalence problem in Fed s response to asset prices. As it can be seen from above Figure 1. when equity price indexes fluctuated significantly Fed responded those asset movements by increasing or decreasing the federal interest rate.the correlation between 13 the interest rate and asset prices that can be observed in Figure 1. can not answer the question of whether it was a traditional monetary policy or an independent concern for asset prices.using ex post data and attempting to identify the effects of asset prices on monetary policy may have a misleading impact Specification of the Taylor Rule: Many scholars all around the world highly interested and used the Taylor rule in the past years.since it can provide an answer to how to set monetary policy by a simple method in this study, the Taylor rule will be the econometric framework that is going to be used in the analysis Estimation Data: As we mentioned above in this study, the Taylor rule will be used as the estimation framework as well as some of the Turkish economic data ranging from 1997:1Q to 2012:4Q., will be used as the estimation data.in the study we will apply RGDP, which is the Turkish real GDP, CPI, which is the consumer price index of Turkey, interest is the interest rate, set by the Central Bank of Turkey and BIST100 which is the stock market value of Turkey to our model to estimate the Taylor rule. The data which we need to carry out our study including GDP, CPI, Interest Rates and BIST100 index of Turkey were extracted from International Monetary Fund International Financial Statistics via UK Data Service international macrodata A Brief Information About Turkish Stock Market: First time in Turkish history on January 3, 1986 stock trading started at the Cagaloglu building of Istanbul Stock Exchange (IMKB) with a number of 80 listed companies.on October,1992 IMKB was accepted to The World Federation of Exchanges as a full member. The legal framework of Turkish capital markets, consist of Capital Markets Law (CML) and Turkish Commercial Code.The more detailed regulations are manifested as Communiqués of Capital Markets Board and Regulations of Stock Exchange. In order to harmonize the Turkish capital markets regulation with the EU acquis, the Capital Markets Law No was enacted by the Turkish law maker.with 14 that amendment in Capital Markets Law Turkish government also aimed to liberalize the activity of running organized markets and re-brand IMKB as Borsa Istanbul (BIST).After the recent changes in the Capital Markets Law Borsa Istanbul is now subject to private law as a joint-stock company. Borsa Istanbul (2013). By the end of 2012, the number of the traded companies on BIST reached to 404 while it was 258 at Under the name of Borsa Istanbul, two major national indices are existed. SERPAM (2013). Those are BIST30 and BIST100.BIST30 is consisted of 30 large companies by the value of outstanding shares traded in the stock market. Financial institutions and a couple of leading holding companies are examples of firm types of the BIST30.BIST100 is the major index of Borsa Istanbul.It is consisted of BIST30 and the following largest industrial companies by the value of outstanding shares traded in the stock market. Usually BIST30 companies have higher beta value than BIST100 companies and BIST30 index also considered as a more reliable indicator about the general trend of the markets The Credit Outlook of Turkey as an Investment Criteria: By the august of 2013, the long-term foreign-currency credit rating of Turkey was confirmed as BB+ by S&P, BBB- by Fitch and Baa3 by Moody s. Moody s and Fitch already upgraded Turkey s foreign-currency sovereign credit rating to the investment grade.another foreign-currency sovereign credit rating upgrade is expected by S&P which will lift the general credit outlook of Turkey to the investment grade in foreigncurrency The Standart Taylor Rule: The Taylor rule which formulates the linear relation between inflation,gdp and the interest rate was established by John B. Taylor in 1993.At this point of the study, the very first step of our econometric analysis consists of estimating the standard Taylor rule (STR) as it is given below as equation (1). ( ) ( ) ( ) 15 According to Taylor (1993), in the above formula represents the log of the interest rate(the federal funds rate), c represents the constant, represents the actual annual inflation rate, represents the desired inflation rate, represents the log of GDP and is the potential GDP. We will assume that in order to keep the analysis simple The Augmented Taylor Rule: Among the monetary policy makers two opposite views emerged regarding how to set a well refined monetary policy. According to the first view monetary authority should not respond to movements in asset prices and wait for to see the progress in the economic data such as the inflation rate. On the other hand, stock market movements could help to predict the future fluctuations in the mon
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