The Investigating of the Dynamic Relationship between Financial Cycles with Business Cycles and the Inflation Gap in Iran: An Application of Wavelet Transform

The 2007 global financial crisis showed that financial cycles is one of the reasons for the fluctuations of macroeconomics and could create business cycles. If there is such a relationship, adopting an active policy response to smooth financial cycles seems necessary. The present study investigates the dynamics of the relationship between financial cycles with business cycles and the inflation gap in Iran's economy during 1990:1 – 2016:4. To accomplish this, first, a financial condition index for Iran's economy has been created. In addition, the causality test has been conducted in the frequency domain and available frequencies have been determined to predict economic growth whit the index. Then, in order to investigate the purpose of the research and analysis in the frequency domain and time-frequency domain, the new Maximal Overlap Discrete Wavelet Transform and Continuous Wavelet Transform tools are used. The results show the relationship between financial cycle and the business cycle in the short run and long run is bilateral and extremely unstable. In the medium run, the business cycle is a leading variable, but the phase difference between the two variables in the 1990s is different from those of the 2000s. In the medium run, the financial cycles have kept inflation away from its long run trend. But in the long run and after 2007, this relationship has been reversed. According to the results of the research, it is recommended that monetary policy makers, in addition to smoothing output and inflation around their long run trends, should also consider this for the financial sector so that the two objectives above can be achieved with lower error in different frequencies.