Testing for Aggregate Instability in an Open Economy

Abstract

This paper empirically tests the Turkish economy’s stability between 2010 and 2016 using a small open economy New-Keynesian model featuring a positive long-run inflation rate and sunspot shock under alternative monetary policy rules. We found that the probabilities of indeterminacy are very close to unity. We can thus conclude that the economy is unstable over this period primarily because the long-run inflation rate is in the higher single digits despite the Central Bank’s weak response to inflation. This drove the economy into aggregate instability.