Inflation Targeting with Emphasis on Real Exchange Rate in Iran's Economy

In general, the main objective of monetary policies is to stabilize the key macroeconomic variables, especially the inflation around its target. However, the role of some variables such as the real exchange rate can be important in optimal monetary policy responses to commodity terms of trade shocks in commodity dependent emerging market economies, such as oil-exporting countries. This study tries to examine the impacts of different monetary policy in order to minimize the adverse effects of the economic shocks, by considering the real exchange rate gap into the flexible inflation targeting rule, in the Iranian economy. Hence, using a new Keynesian model, the demand and Phillips curves are estimated by autoregressive distributed lags (ARDL) method, based on the quarterly data during 1991:Q1-2014:Q4 and then a loss function for the central bank is minimized subject to above equations, by using the optimal control approach. According to the results, when the real exchange rate gap is calculated based on the lower targets, existence of this variable in the loss function of the monetary authorities lead to lower losses. But the higher real exchange rate gap is accompanied by higher losses. For summary, dependent on the real exchange rate gap, the monetary author can use the target of the exchange rate as a policy target. However, the flexible inflation targeting monetary framework, with regards to real exchange rate targeting, is not optimal policy in case of more rigid exchange rate regimes.