Budget deficits real exchange rate nexus: Evidence from Turkey

This study investigates the long-term relationship between budget deficits and the real effective exchange rate in Turkey, covering the period from 1994 to 2022. The significance of this relationship is explored due to Turkey's historical tendency towards budget deficits, except for a few instances of balanced budgets. The real effective exchange rate, adjusted for price levels and inflation rates, is particularly volatile during periods of high budget deficits, impacting both domestic markets and foreign trade balance. The study employs Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) unit root tests to determine the stationarity of the series. The results reveal that both budget deficits and real effective exchange rates are non-stationary at levels but become stationary at first differences, indicating the presence of unit roots. Subsequent analysis using the Autoregressive Distributed Lag (ARDL) boundary test approach identifies a significant long-term cointegration relationship between these variables, suggesting a balanced interaction over time. Diagnostic tests, including the Ramsey-RESET, Breusch-Godfrey LM, and Breusch-Pagan-Godfrey, confirm the model's reliability, showing no autocorrelation or heteroscedasticity issues. The short-term error correction model indicates a functional adjustment mechanism, where deviations correct themselves over time. The study concludes that fiscal discipline and stability in the real exchange rate are crucial for Turkey's economic stability and growth. This research provides insights for policymakers on the interdependence of budgetary policies and exchange rate dynamics, highlighting the need for prudent fiscal management and exchange rate policies. Keywords Budget Deficits, Real Exchange Rate, Real Effective Exchange Rate, ARDL Boundary Test, Turkey, Fiscal Policy