Dynamics of Monetary Aggregates, the Exchange Rate and Their Relationship with Inflation in Iran

The prevalent narrative regarding the surge of inflationary pressures in the Iranian economy over the past five years emphasizes the growth of lending by the banking system. Monetary policy over the last few years has also focused on limiting the growth of broad money aggregates. However, despite a substantial reduction in the growth rate of M2, the rate of inflation has persisted above the long-run trend. Naturally, questions arise whether higher rates of inflation since 1397 are the consequence of higher monetary growth rates or whether other factors can explain the recent bouts of elevated inflationary pressures. Moreover, how effective is the announced policy of targeting the growth rate M2 aiming at reducing the inflation rate in the short and the long run? The present study proposes that the concurrence of three different but related factors - exchange rate fluctuations, weakening of asset demand for rial, and the lack of an effective policy anchor to curb inflationary expectations - provide a more accurate and complete narrative than a simple monetary explanation. We employ a structural vector autoregression model for short-run analysis and a vector error correction specification for the long-run analysis to identify which macroeconomic variables have had a more significant role in generating inflationary pressures during the 1367Q2-1402Q2 period.