Economic Structure, Policy Purposes and Optimal Interest Rate in Inflation Targeting

Central banks regard the interest rate as a tool for achieving different economic objectives such as inflation targeting. Interest rate plays an important role in the economic structure of a country and given the dependence of other macroeconomic variables, such as the level of production and employment, and their effects on interest rate behaviors, so, the interest rate has been regarded by policy makers as a major instrument of monetary policy. In this paper, regarding the Iranian economic structure and on the basis of Sevensson’s model (1997), the optimal interest rate has been computed with respect to the major goals of central banks. The solution to the model on the basis of some simplified assumptions shows that the real optimal interest rates are affected by the gap between inflation and inflation target, production gap, the inflation lag, and exogenous variables. Estimation of the model using Iranian economic data (1974- 2007) reveals that the relationship between inflation and the production gap as well as inflation and inflation gap is positive and significant. Furthermore, the production gap has a positive and significant relationship with the lag in the production gap, a negative and insignificant one with the real interest rate, and a negative and significant one with exogenous variables. Estimation of the optimal interest rate model shows that the production gap has a positive and significant effect on the nominal interest rate. The effect of exogenous variables on the nominal interest rate is positive and significant, and targeted inflation has a negative and statistically significant impact on the nominal interest rate. In addition, the results of this paper demonstrate that the effect of inflation and it's lag is not statistically significant on the nominal interest rate.