Inflation Drives Currency Depreciation

Steps:

• The Turkish lira depreciated sharply against major currencies from 2016 to 2021.
• Exchange rates are influenced by inflation differentials, interest rates, trade balances, and fiscal health.
• Historical data shows Turkey experienced hyperinflation exceeding 80% by 2022, eroding lira's value.
• Among options, rising inflation directly explains sustained depreciation via reduced purchasing power.

Why D is correct:

• Purchasing power parity theory states that higher domestic inflation relative to trading partners causes currency depreciation to equalize price levels.

Why the others are wrong:

• A: A fall in import demand reduces lira supply in forex markets, appreciating the currency.
• B: Lower government debt improves fiscal credibility, attracting investment and strengthening the lira.
• C: Higher interest rates draw foreign capital inflows, increasing lira demand and appreciation.

Final answer: D