The IS Curve, the Phillips Curve and Monetary Transmission in Iran Economy

The purpose of this paper is to examine the mechanism of monetary and fiscal policy transmission based on the framework of the new Keynesian model. The new Keynesian framework is a combination of the features of the dynamic stochastic general equilibrium of the real business cycle model and the Keynesian theory. In the New Keynesian dynamic general equilibrium model, the consumers face liquidity restriction and the firms face sticky prices. In this model, money has no obvious role. Of course, that doesn't mean money doesn't matter. Money is still the center of attention but invisible. The present paper studies the monetary policy rule jointly with fiscal rules through the estimation of a three-equation New Keynesian model (aggregate demand (IS), monetary rule, aggregate supply (Philips curve)). The presented model is estimated by systematic generalized methods of moments using Iran's data from 1989Q1-2017Q4. The obtained results show that the aggregate demand responds to the changes in interest rate and that the coefficient of consumers ‘consumption habits is significant. Also, inflation (regardless of its source) seems to be persistent and inertia. On the other hand, this research indicates that the monetary policy has a forward looking behavior; the output gap with a lag has a negative influence on government expenditure. The short term impact of output gap on government expenditure is less than its effect on taxation. That is tax reaction is positive and stronger compared to output gap reaction. Since monetary and fiscal policy can play a pivotal role in stabilizing the economy, it is recommended to implement a true and precise fiscal policy to pave the way for an active monetary policy using the new Keynesian model.