Relative productivity increases and the appreciation of the Turkish lira Kenan Lopcu a, ⁎, Fikret Dülger b,1 , Almıla Burgaç b,1 a Department of Econometrics, Çukurova University, Balcalı, Adana 01330, Turkey b Department of Economics, Çukurova University, Balcalı, Adana 01330, Turkey abstract article info Article history: Accepted 6 August 2013 JEL classification: C22 E31 F31 Keywords: Balassa–Samuelson hypothesis Real effective exchange rate Relative productivity Cointegration Multiple structural breaks This paper studies the Balassa–Samuelson hypothesis between Turkey and 27 members of the European Union. More specifically, using recently developed cointegration techniques with multiple breaks, we test the relation- ship between the real effective exchange rate and inter-country differences in the relative productivity of the tradable and non-tradable sectors over the period 1990:Q1–2011:Q2. In recent years, the Central Bank of the Republic of Turkey (CBRT) has emphasized the importance of the B–S hypothesis for Turkey. Our findings, however, suggest that changes in relative productivity have played a limited role in explaining the real effective exchange rate appreciation. In particular, the relationship between the real effective exchange rate and produc- tivity indicated by the Balassa–Samuelson hypothesis is not supported for the post 2001 era in Turkey. © 2013 Elsevier B.V. All rights reserved. 1. Introduction The Balassa–Samuelson (B–S) hypothesis (Balassa, 1964; Samuelson, 1964) identifies inter-country differences in relative productivity of trad- able and non-tradable sectors as the main source of long-run changes of real exchange rates (and hence, deviations in purchasing power parity). The Central Bank of the Republic of Turkey (CBRT) in recent years has endorsed the importance of the Balassa–Samuelson hypothesis for Turkey by stating 2 : … [D]ifferences in productivity and relative price differences appear to have been moving together recently. In conclusion, productivity increases and the differentiation in price increases in the tradable and non-tradable goods are among the factors shaping the develop- ment of the real exchange rate in Turkey … [A] close relationship is being observed in the Turkish economy between the relative price differentiation in tradable and non-tradable goods, and the increase in productivity. … [S]ome part of the real appreciation of the New Turkish lira stemmed from the rapid increase in productivity in re- cent years. The strong stance of the New Turkish lira will continue to be supported via this channel, under the assumption that the in- creases in productivity would prevail in the upcoming real conver- gence process with the EU (CBRT, 2006, p. 33–34). Briefly, according to the CBRT, part of the appreciation of the Turkish lira (TL) can be attributed to the productivity differentials between trad- able and non-tradable sectors. In particular, in addition to the direct ef- fects of structural reforms undertaken after the 2001 crisis, increased confidence, optimism, and macroeconomic stability in recent years have contributed to the strengthening of the national currency through the relative price differentials between tradable versus non-tradable goods (CBRT, 2006). The main purpose of this study, given the increased consideration of the B–S effect by the CBRT, is to test whether part of the appreciation of the TL is driven by the relatively rapid productivity increases in the trad- able sectors in recent years. Hence, the study examines the validity of the B–S hypothesis between Turkey and 27 member countries of the European Union (EU-27), which include the majority of Turkey's main trading partners, for the post-financial liberalization era (i.e., 1990: Q1–2011:Q2), using recently proposed cointegration techniques with multiple structural breaks by Kejriwal (2008). Our analysis offers very limited support for the B–S hypothesis. In particular, the presence of the B–S effect is generally limited to the pre-2001 period, and in some cases even to the pre-1994 period. We do not find any support for the B–S hypothesis from the data for the post-2001 era. Our results are robust to alternative specifications and additional controls, and hence, undermine the increased consideration of the B–S effect by the CBRT. Economic Modelling 35 (2013) 614–621 ⁎ Corresponding author. Tel.: +90 322 338 72 65; fax: +90 322 338 72 83. E-mail addresses: klopcu@cu.edu.tr (K. Lopcu), fdulger@cu.edu.tr (F. Dülger), aburgac@cu.edu.tr (A. Burgaç). 1 Tel.: +90 322 338 72 66. 2 The CBRT has been applying explicit inflation targeting strategies since 2006. Inflation reports issued by the CBRT on a quarterly basis are closely followed by economic agents in Turkey. 0264-9993/$ – see front matter © 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.econmod.2013.08.005 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod