EXCHANGE RATE REGIMES AND PASS-THROUGH: EVIDENCE FROM THE TURKISH ECONOMY HAKAN KARA, HANDE KU ¨ C xU ¨ K-TUG ˘ ER, U ¨ MIT O ¨ ZLALE, BURC x TUG ˘ ER, and ERAY M. YU ¨ CEL* We seek to demonstrate the variations in the exchange rate pass-through (ERPT) and identify the shift in the price-setting behavior by placing the emphasis on the implemented exchange rate and monetary policy regimes. Having a history of several distinct monetary regimes, Turkey exhibits a genuine laboratory in this respect. Our empirical results reveal that the pass-through from exchange rates to domestic prices has changed dramatically. We detect breaks in the pass-through coefficients at three episodes, all of which coincide with a shift in monetary/exchange rate regime, lending support to the view that monetary and exchange rate regimes might be among the major determinants of the ERPT process.(JEL C51, E31, E58) I. INTRODUCTION Understanding and quantifying the impact of exchange rate shocks on the domestic prices has always been of interest to both academi- cians and the central banks. The fact that in recent years most of the emerging market econ- omies abandoned fixed exchange rate regimes in favor of inflation-targeting (IT) regimes makes this question even more interesting: Most of the emerging market economies have lived with fixed exchange rate regimes for many years. These regimes, by definition, create a strong relation between nominal exchange rates and other nominal variables such as the price level. Switching to a floating exchange rate regime along with an IT strategy is expected to weaken the relationship between exchange rates and the other nominal variables and, hence, alter the pass-through process. The Turkish economy, which has adopted floating exchange rate regime after years of managed/pegged exchange rate regimes, is an interesting laboratory in this respect. Using Turkey as an experimental environment, this study discusses the relation between exchange rate and prices (pass-through) in small open- emerging market economies. We aim to analyze the evolution of ‘‘exchange rate pass-through’’ (ERPT) process, demonstrate the change (if any) in this process, and identify the determi- nants of this change. Thus, the main contribu- tion of this article is to reveal the factors behind the change in the ERPT, placing the central emphasis on different policy regimes. Our empirical results reveal that the pass- through of exchange rates to domestic prices has gone down after adopting a floating exchangerateregime.Forexample,underapar- ticular specification, we find that the exchange pass-through to inflation has dropped from its prefloat level of 68% to 15% for traded sector. *We thank three anonymous referees for valuable comments. All the views expressed in this article are those of the authors and do not necessarily represent the views of the Central Bank of Turkey or its staff. Kara: Research and Monetary Policy Department, Cen- tral Bank of Turkey, Istiklal Cad. 10, 06100-Ankara, Turkey. E-mail: hakan.kara@tcmb.gov.tr Ku¨c xu¨k-Tug˘ er: Research and Monetary Policy Department, Central Bank of Turkey, Istiklal Cad. 10, 06100- Ankara, Turkey. E-mail: hande.kucuk@tcmb.gov.tr O ¨ zlale: Associate Professor of Economics, Department of Economics, TOBB University of Economics and Tech- nology, Sogutozu, 06560-Ankara, Turkey. E-mail: ozlale@etu.edu.tr Tug˘ er: Research and Monetary Policy Department, Central Bank of Turkey, Istiklal Cad. 10, 06100-Ankara, Turkey. E-mail: burc.tuger@tcmb.gov.tr Yu¨cel: Research and Monetary Policy Department, Cen- tral Bank of Turkey, Istiklal Cad.10, 06100-Ankara, Turkey. E-mail: eray@erayyucel.info ABBREVIATIONS CBT: Central Bank of Turkey CPI: Consumer Price Index ERPT: Exchange Rate Pass-Through GDP: Gross Domestic Product IT: Inflation Targeting SUR: Seemingly Unrelated Regressions TL: Turkish Lira TVP: Time-Varying Parameter USD: US Dollar VAR: Vector-Auto Regression WPI: Wholesale Price Index Contemporary Economic Policy (ISSN 1074-3529) Vol. 25, No. 2, April 2007, 206–225 doi:10.1111/j.1465-7287.2007.00037.x Online Early publication January 24, 2007 Ó 2007 Western Economic Association International 206