Analyzing the Impact of Monetary Policy Instruments on Inflation in Iran: A Bayesian TVC-VAR Approach

Purpose: Inflation has been a persistent and critical challenge in Iran's economy, necessitating Inflation has been a persistent and critical challenge in Iran's economy, necessitating a comprehensive understanding of its drivers and mechanisms for effective policy formulation. This study focuses on the interconnected roles of the key monetary policy tools, including liquidity, exchange rates, interest rates and base money, in inflation dynamics. Drawing upon the global perspective of inflation control, which includes exchange rate targeting, monetary aggregates and inflation targeting, the research adapts these insights to Iran's unique economic context.
Using a Bayesian TVC-VAR model, the study captures the structural shifts and the evolving relationships among the corresponding variables from May 2014 to August 2024. The model’s strength lies in addressing the complex and interdependent nature of Iran’s macroeconomic variables, where changes in one variable can significantly impact others.
The research highlights two pivotal periods: May 2018, marked by the U.S. withdrawal from the JCPOA, and August 2020, shaped by intensified sanctions and the COVID-19 pandemic. These periods underscore the importance of adaptive and coordinated monetary and exchange rate policies. The findings provide policymakers with workable insights to mitigate inflationary pressures and foster economic stability in an unpredictable environment.
Methodology: This study employs the Bayesian TVC-VAR model, which builds on the traditional VAR framework by incorporating time-varying coefficients, enabling it to capture the evolving nature of economic relationships. The model uses monthly data spanning May 2014 to August 2024, sourced from the Central Bank of Iran. The key variables include the following:
Inflation (CPI): A proxy for the general price level in the economy
Liquidity: Representing the total money supply, influenced by the base money multiplier effect
Base Money: High-powered money, including currency in circulation and bank reserves
Exchange Rate: The value of the Iranian Rial against foreign currencies
Interest Rate: Represented by the interbank rate, a proxy for general borrowing costs
The data were log-transformed and seasonally adjusted to ensure consistency. Unit root tests confirmed stationarity for all the variables except the interest rate, which required adjustments for structural breaks. To identify structural shocks, Cholesky decomposition was done, with the variables ordered as base money, exchange rate, liquidity, interest rate, and inflation. This hierarchy reflects the foundational role of base money in driving monetary aggregates and the lagged responses of inflation.
The study focuses on two critical periods as follows:
May 2018: The U.S. withdrawal from the JCPOA, which triggered significant economic and political uncertainty, leading to heightened exchange rate volatility and inflationary pressures
August 2020: A period of compounded economic crises due to the COVID-19 pandemic and intensified sanctions, which further disrupted economic stability
Findings and discussion: The analysis reveals significant insights into the relationships between inflation and the key monetary policy variables. Shocks to liquidity had a moderate and short-lived impact on inflation. Following an increase in liquidity, inflation rose moderately, peaking after a few periods before stabilizing.
The influence of liquidity was less pronounced than that of base money or exchange rate shocks, suggesting that the impact of liquidity on inflation is mediated through other variables.
Exchange rate shocks exhibited the most immediate and significant impact on inflation. Depreciation of the Rial directly increased import prices, leading to a sharp and immediate rise in inflation.
The magnitude of the impact was particularly pronounced in August 2020 due to combined economic crises. Inflation surged following an exchange rate shock and stabilized after approximately five periods.
Interest rate shocks negatively affected inflation, demonstrating their effectiveness as a tool for controlling price levels. An increase in the interbank interest rate reduced inflation by curbing borrowing and aggregate demand.
The effects of interest rate shocks were temporary, lasting for about 10 periods in May 2018 and 5 periods in August 2020 before inflation returned to its baseline.
Shocks to base money had a pronounced and prolonged impact on inflation. Increases in base money, often used to finance government deficits, led to rapid inflationary pressures that persisted longer than those caused by liquidity shocks.
The findings emphasize the critical role of base money as a driver of inflation, both directly and through its effects on liquidity and aggregate demand.
Comparing the two critical periods, the study found consistent qualitative responses across the variables but differing magnitudes. The responses were more intense in August 2020, reflecting the heightened economic instability due to the combined effects of the COVID-19 pandemic and the external sanctions. The exchange rate shocks consistently had the most substantial impact on inflation, highlighting the critical importance of exchange rate stability in managing price levels.
Conclusions and Policy Implications: This study underscores the significant role of monetary policy tools in shaping inflation dynamics in Iran. The Bayesian TVC-VAR model provided a nuanced understanding of the evolving relationships between inflation, exchange rates, interest rates, liquidity, and base money, offering valuable insights for policymakers:
Exchange rate shocks have significant effects on inflation, making effective exchange rate management a policy priority. Implementing mechanisms to mitigate sharp currency fluctuations can play a crucial role in stabilizing prices and preventing sudden inflationary surges. This effort requires precise coordination between monetary and exchange rate policies.
Given the positive impact of the interbank interest rate on controlling inflation, policymakers are advised to use this tool strategically while considering market conditions. Smart use of interest rates can help curb inflation by managing liquidity and channeling financial resources into productive economic sectors.
The findings indicate that base money and liquidity shocks have substantial effects on inflation. Therefore, policymakers must closely monitor the growth of these two variables and prevent their excessive expansion. This requires implementing appropriate monetary policies and enhancing financial transparency to strengthen public trust and optimize policy effectiveness.
The rapid response of the variables to exchange rate shocks underscores the need for policymakers to establish mechanisms and structures to quickly identify these shocks and adopt effective, timely responses. Building such frameworks, especially during crises, can prevent severe economic fluctuations and minimize their negative impacts.