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                       Asian Finance & Banking Review; Vol. 3, No. 1; 2019 

                                       ISSN 2576-1161   E-ISSN 2576-1188 

Research Article               Published by Centre for Research on Islamic Banking & Finance and Business, USA 

 

     74 
 

Inflation Targeting in Iran 

 

Bijan Bidabad
1  

          Nahid Kalbasi Anaraki
2
 

 

Abstract 

Inflation targeting in various forms has been adopted by a number of countries as a framework for making monetary 

policy more coherent and transparent and for increasing the credibility of monetary policy. Despite the language, 

referring to inflation target as the primary objective of monetary policy, central bankers always make room for 

short-run stabilization objectives, particularly with respect to output and exchange rate. Inflation targeting, in most 

cases, reduces the role of intermediate targets, such as exchange rate or money growth rate. 

Experience of other countries that have adopted inflation targeting as a monetary framework reveals that the success 

of the policy depends on not only the transparency of the operation but also on the budgetary discipline. Indeed, the 

central banks that have become more transparent, more independent, more coherent, and more accountable and more 

credible have been more successful. 

The controversy among economists on the expenses of inflation targeting has attained particular attention during the 

past decades .While opponents believe that inflation targeting takes place at the expense of output shortfalls 

(Cechetti and Ehrmann 1999), proponents (Mishkin 2000, Jonas and Mishkin 2003) believe that inflation targeting 

promotes investment and economic growth. This paper tries to address the question of whether the performance of 

inflation targeting in Iran has been successful. Based on a  monetary model, using exogenous variables such as 

official exchange rate, budget deficit, foreign exchange obligation account, and balance of payments, the results 

suggest that the effects of inflation targeting on the real output is trivial, supporting the natural rate hypothesis.  

Keywords: Inflation Targeting, Macro-Econometric Model, Monetary Policy 

1. Introduction 

Indeed, the unhappy experience of the Latin America and East Asian countries with pegged exchange rate regimes 

who subsequently found themselves in deep financial crisis in the late 1990s has induced other countries to search for 

alternative nominal anchors. The emergence of inflation targeting over the past decade has been seen as a 

development in the approach of central banks to the conduct of monetary policy. After the adoption by New Zealand 

in 1990, inflation targeting has been the choice of a growing number of central banks in industrial and emerging 

economies, including Canada, Brazil, Chile, the Czech Republic, Poland, Sweden, and the U.K. 

Inflation targeting is a monetary policy strategy that encompasses five main elements: (i) the public announcement of 

the medium-term numerical target for inflation (ii) an institutional commitment for price stability (iii) an information 

inclusive strategy in which, many variables, and not just monetary aggregates or the exchange rate are used for 

deciding the set of policy instruments (iv) increased transparency of the monetary policy strategy through 

communication with the public and the markets about the objectives, and decisions, (v) increased accountability of the 

central bank for attaining its inflation objectives.  

Inflation targeting proponents cite many benefits to this policy, including solving the dynamic inconsistency problem 

that produces a high inflation rate and reducing inflation variability. Inflation targeting has also the key advantage that 

is easily understood by the public and thus is highly transparent. And last but not least, if flexible, it helps to stabilize 

output as well.  

                                                             
1 (B.A., M.Sc., Ph.D., Post-Doc.) Research Professor of Economics, Monetary and Banking Research Academy,      

bidabad@yahoo.com     bijan@bidabad.com        http://www.bidabad.com . 

2 Nahid Kalbasi Anaraki, Faculty Member, Monetary and Banking Research Academy, E-mail: nkalbasi@aol.com 

mailto:bidabad@yahoo.com
http://www.bidabad.com/
mailto:nkalbasi@aol.com


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75 
                           

Critics of inflation targeting have noted major disadvantages: (i) inflation targeting is too rigid (ii) it allows too much 

discretion (iii) it has the potential to increase output instability (iv) it will lower economic growth (v) it produces weak 

central bank accountability because inflation is hard to control and because there are long lags from the monetary 

policy instruments to the inflation outcome (vi) exchange rate flexibility required by inflation targeting might cause 

financial instability, (vii) and finally, it may not be sufficient to ensure fiscal discipline or prevent fiscal dominance.   

Indeed, a relatively long list of requirements should be met if the inflation targeting is to operate successfully. These 

requirements include: (i) a strong fiscal position (ii) a well understood transmission mechanism between monetary 

policy instruments and inflation (iii) a well developed financial system (iv) a clear mandate for price stability (v) 

absence of other nominal anchors than inflation (vi) transparency and accountability of monetary policy. Indeed, it is 

not possible to say whether a country meets these requirements or not: it is more a question of the degree to which 

these preconditions are met. 

One decade of inflation targeting in the world offers useful lessons on the design and implementation of this 

framework. Since the Iranian economy has started to adopt inflation targets in the medium-term through the Five Year 

Development Plans since 1989, this paper tries to investigate the feasibility of the targets within a monetary model. 

Moreover, it tests the hypothesis a trade-off between inflation targeting and real output.   

In the next section, we review the performance of countries that have adopted inflation targeting. Section III is 

allocated to the inflation targeting and monetary policy instruments in Iran. Section IV presents the estimated results 

of a monetary model, measuring the trade-off between inflation and real output. And finally, the last section rap up 

and concludes.  

2. Experience of other countries 

In this section, we try to investigate the success of reducing inflation in some countries which adopted this policy. 

Moreover, we will investigate whether the reduction in inflation rate has occurred at the cost of real output reduction. 

Cechetti and Ehrmann (1999) chose 23 countries where 9 have performed some targeting for reducing inflation. They 

show that for the latter group inflation fell by more than 7 percentage points on average, from 10.82 percent in the late 

1980s to 3.41 percent in the late 1990s, whereas for the non-targeted the average reduction amounts to 3.6 percent. 

Indeed, inflation targeting has achieved its primary objective of lowering inflation. Moreover, the output and inflation 

statistics support the view that inflation targeters have reduced inflation at the expense of an increase in output 

volatility. Indeed, the outcome depends on many issues, including a country's economic structure, its policy regime, 

and the actual pattern of shocks it has faced.3 

In another study, Frederic S. Mishkin (2000) investigates inflation targeting in an emerging economy, Chile. Before 

embarking the inflation targeting, passed new central bank legislation in 1989, which gave independence to the central 

bank and mandated price stability as one of its primary objectives. Chile's central bank pursued a very gradualist 

approach to lowering its inflation objectives. The Chilean experience was quite successful. Inflation fell from about 
20% in 1991 to around 3.5% in 2000. Over the same period, output growth was very high, averaging more than 8 

percent per year. Chile experienced that inflation targeting can be used as a successful strategy for gradual disinflation 

in emerging market countries, even when initial inflation is around 20%. It is important to notice that inflation 

targeting cannot be solely attributed to the actions of the central bank, supervision policies, such as the absence of 

fiscal deficits and supervision of the financial sector have been crucial to its success.     

Jonas and Mishkin (2003) in their paper "Inflation Targeting in Transition Countries: Experiences and Prospects" 

examine the inflation targeting experience in three transition economies of the Czech Republic, Poland, and Hungary. 

A key lesson from the experience of inflation targeting in transition countries is that their economic performance has 

been improved. All these countries have an independent central bank with a clear mandate to pursue price stability. 

There has also been significant progress in making more transparent monetary policy decision and more accountable 

central banks. Financial markets are relatively well developed, allowing for reasonably effective transmission 

mechanism between monetary policy instruments and inflation.  

With respect to fiscal position, fiscal deficits have widened significantly, particularly in the Czech Republic and 

Hungary. However, these deficits have not yet posed direct problems to inflation targeting in the sense of fiscal 

                                                             
3 -Cecchetti S. And M. Ehrmann "Does inflation targeting increase output volatility? An international comparison of policy 
makers' preferences and outcomes", NBER working paper 7426, Dec 1999. 



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76 
                           

dominance of monetary policy because they have been financed by non-monetary means. Moreover, these countries 

have a regime of managed float, and inflation is the only nominal anchor in the economy. The experience of these 

transition countries shows that all three countries are preceding well with disinflation and there is a good chance that 

in a few years, they should be able to reach price stability. However, the process of disinflation is not a smooth one. In 

this respect, one should bear in mind that countries could be quite successful in the longer term in bringing inflation 

down, but if a successful disinflation is accompanied by significant instability of inflation, this could be costly for the 

economy as well. 

There is not yet much we can say about the history of inflation targeting in Hungary because it is so recent. The 2001 

target was announced only in August 2001, and it, therefore, was more a short-term inflation forecast than an actual 

inflation target. Table (1) presents the history of inflation targeting in the Czech Republic and Poland, telling a 

different story.  

As it is seen in the above Table, in the Czech Republic, the central bank undershot her inflation target, particularly in 

1998 and 1999. Only in 2001 the central bank succeeded in achieving her inflation targeting but undershot its target 

again in 2002. In Poland, there was an opposite problem since the national bank of Poland (NBP) overshot her target 
in 1999 and 2000. Very tight monetary policy and slowing economic activity helped to bring inflation down sharply in 

2001, and subsequently, the 2001 and 2002 targets were undershot quite sizable. These deviations may seem to 

suggest that inflation targeting was not very successful in the Czech Republic and Poland.  

Table (1). Targeted and actual inflation in the Czech Republic and Poland 

Country Czech Republic (inf) Czech Republic (inf) Poland (inf) Poland (inf) 

Year Target Actual Target Actual 

1998 5.5-6.5 1.7 X 8.6 

1999 4-5 1.5 6.4-7.8 9.8 

2000 3.5-5.5 3 5.4-6.8 8.5 

2001 2-4 2.4 6-8 3.6 

2002 2.75-4.75 0.5 4-6 0.8 

Source: Jonas and Mishkin, "Inflation Targeting in Transition Countries: Experience and Prospects", NBER, working 

paper 9667, April 2003, p23. 

Before making any definitive judgment about the success or failure of inflation targeting, it is important to understand 

the reasons for such significant deviations from targeted inflation. We have to examine more closely the domestic and 

external economic circumstances that have prevailed during this period and have affected the actual inflation. At the 

time that Czech central bank launched inflation targeting, inflation was rising quite rapidly, but at the same time, the 
economy was slipping into a prolonged recession. The 1998 and 2000 targets were specified at that time when the 

central bank, public and private forecasters expected much stronger economic growth than what actually occurred. 

However, in 1998-99 with the onset of a major banking crisis in 1997-98, economic activity fell down and contributed 

to a much faster disinflation than envisaged by the central bank. Moreover, in 1997-98, weak global economic activity 

contributed to falling commodity prices, including energy prices. The central bank calculations suggest that these 

external factors had a sizeable effect on net inflation; for instance, in 1998, these factors reduced the inflation by 2-3 

percentage points. 

Like in the Czech Republic, inflation in Poland had declined significantly during 1998 and 1999, but this decline was 

less dramatic. The relatively rapid economic growth of domestic demand, increase in import prices, and monopolistic 

structure of some industries resulted in a reversal of disinflation in Poland in 1999. Fiscal policy was also much more 

expansionary than the national bank of Poland (NBP) had expected, and this expansionary stance further fueled 

domestic demand. The NBP responded to these developments by significant tightening of the monetary policy, and it 

continued to keep monetary conditions very tight even when inflation began to fall sharply later in 2000 and 2001. 

Indeed, the NBP tried to use a tight monetary policy stance as an instrument to force the government to strengthen the 

structural fiscal balance, even at the cost of significant undershooting of its inflation target. 

Judging from the success point of view in meeting its inflation target, the NBP has not been very successful, thus far. 

In the first two years, inflation targets were overshot, and in the third and fourth years, there was a significant 

undershooting. Indeed, in Poland, external factors may have been of less importance in explaining the failure to meet 

inflation targets than in the Czech Republic, while the conduct of macroeconomic policy has probably mattered more. 



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77 
                           

First, unexpected fiscal expansion combined with easy monetary policy contributed to the acceleration of inflation and 

overshooting of inflation targets; and subsequently, sharp tightening of monetary policy, in the absence of further 

easing of fiscal policy, reduced inflation sharply and produced a significant undershooting of the target. A difficult 

problem for inflation targeting in transition countries is the stormy relationship between the central bank and the 

government. This can be alleviated by having a direct government involvement in the setting of the inflation target and 

with a more active role of the central bank in communicating with both the government and the public.   

Table (2). CPI Inflation Rates in Canada, New Zealand, Sweden, and the U.K. 

Year Canada New Zealand Sweden The U.K. Industrial countries 

1977-1986 7.5 13.1 9.2 9.5 7.3 

1987 4.4 15.7 4.2 4.1 3.1 

1988 4.0 6.4 5.8 4.9 3.4 

1989 5.0 5.7 6.4 7.8 4.4 

1990 4.8 6.1 10.5 9.5 5.0 

1991 5.6 2.6 9.3 5.9 4.5 

1992 1.5 1.0 2.3 3.7 3.3 

1993 1.8 1.3 4.6 1.6 3.0 

1994 0.2 1.7 2.2 2.5 2.4 

1995 2.1 3.7 2.5 3.4 2.6 

1996 1.6 2.3 0.5 2.4 2.4 

1997 1.5 1.1 0.5 3.2 2.1 

1998 0.9 1.2 -0.1 3.4 1.5 

1999 1.7 -0.1 0.4 1.5 1.4 

2000 2.7 2.5 0.9 2.8 2.2 

2001 2.5 2.7 2.4 1.8 2.2 

2002 2.2 2.6 2.1 1.6 1.5 

Source: IMF, International Financial Statistics and IMF Outlooks, 

Following McCallum (1996), we investigate inflation targeting arrangements in Canada, New Zealand, Sweden, and 

the United Kingdom, all of which adopted inflation targets between 1990 and 1993. A striking feature of the four 
arrangements is the similarity of the feedback procedures used by the central banks of these nations. In all of them, 

money market conditions were tightened or loosened when inflation forecasts for a year ahead lie outside the target 

range, whose width is 2 percent. To address the question of whether the performance of these countries has been 

successful, CPI inflation rates are reported in Table (2). For comparison, average CPI inflation rates across 

industrialized nations are reported in the final row. 

As it is seen in Table (2) over the reported years prior to 1990, the four countries all had inflation rates that were 

higher than the average. In contrast, during 1992, 1993, and 1994, three of these countries experienced less inflation 

than the average of industrial countries. Whether or not, this outcome is a result of inflation targeting schemes per se; 

it would seem to be the case that the monetary policy stance has altered in these four countries. Moreover, as it is seen 

in the above-mentioned Table, the inflation rate has been lower than the average of industrial countries from 1994 to 

1999 in four countries, except for the U.K. and for New Zealand in 1995, supporting the success of inflation targeting 

strategy. 

Table (3) reports the real GDP growth rates for the four inflation targeting countries and the average value for the 

industrial countries. In these figures, one can find that undesirable real effects were generated by the adoption of anti-

inflationary measures. However, there has been an encouraging revival of growth since 1993, output growth rates 

above the industrial average were recorded in Canada, Sweden, and the United Kingdom. All in all, the results suggest 

that the four inflation targeters have experienced higher economic growth than the industrial average except for New 

Zealand in 1997 and 1998. 

 

 

 



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Table (3). Real GDP Growth Rates in Canada, New Zealand, Sweden, and the U.K. 

Year Canada New Zealand Sweden The U.K. Industrial countries 

1977-1986 3.1 1.6 1.7 2.1 2.7 

1987 4.2 -1.7 3.1 4.8 3.2 

1988 5.0 3.0 2.3 5.0 4.4 

1989 2.4 -0.5 2.4 2.2 3.3 

1990 -0.2 -0.1 1.4 0.4 2.4 

1991 -1.8 -2.1 -1.1 -2.0 0.8 

1992 0.6 -0.2 -1.9 -0.5 1.5 

1993 2.2 4.1 -2.1 2.2 1.2 

1994 4.5 4.8 2.2 3.8 3.0 

1995 2.77 3.7 3.7 5.5 2.8 

1996 1.7 3.0 1.0 5.9 3 

1997 3.9 2.5 2.0 6.4 3.5 

1998 3.5 -0.4 3.6 6.0 2.7 

1999 15.8 4.1 4.5 4.9 3.4 

2000 9.2 2.0 3.6 4.7 3.9 

2001 3.9 4.3 1.2 4.5 1 

2002 4.2 - 3.6 5.6 1.8 

Source: IMF, International Financial Statistics, and IMF Outlook. 

3. Inflation Targeting in Iran 

Before implementing the First and Second Five Year Development Plan there is no record of inflation targeting in 

Iran, however, during the first two plans (1989-1994 and 1996-2001) inflation targets have been set within the plans. 

Though there are some similarities between inflation targeting in Iran and other countries, the targets stand at much 

higher levels in Iran compared with other countries. For instance, The Second Five Year Development Plan 

envisaged an inflation target of 12%, and the Third Development Plan targeted an inflation rate of 15%.  

Indeed, to achieve the goals, monetary authorities need to implement all the monetary instruments effectively. 

However, in Iran, due to the lack of central bank independence and administrative, regulatory, monetary authorities 

have been being unable to use money market operations, discount rate, and the reserve requirement effectively. As a 

result, monetary authorities have not succeeded to achieve the goals, undermining the credibility of the policies. 

The decomposition of the monetary base in Iran, since the revolution (1978), reveals that the government debt to 

central bank has adversely affected the effectiveness of monetary instruments. On the other hand, the monetary 

instruments have been limited through the Islamic Banking Law approved in 1982. Indeed, under current 

circumstances, the only means to control the money supply are through the reduction of government debt to the 

central bank and also increasing the reserve requirement ratio. The legal framework for controlling government debt 
has been envisaged in the five-year development plans and the budget laws. Accordingly, credit ceilings have been 

set with emphasize on the monetary authorities' responsibilities to react against any increase in the money supply.  

Though the government deficit has been controlled according to the budget law and the plan, the foreign exchange 

obligation account4 increased enormously during the past decade. The government used this account to service its 
foreign debts with the official exchange rate, which has enlarged the money supply, in turn. The major challenge 

that the government faces with is the lack of fiscal discipline, which in turn, may lead to the failure of inflation 

targeting as a framework for monetary policy. Indeed, the dominance of the fiscal sector on the monetary authorities 

has undermined the independence of the central bank, leaving small room for the success of inflation targeting 

strategy. 

As the credit ceilings are determined for a financial year within the budget, they should be allocated on a monthly 

basis and announced to the banks. In case, there is a violation from the credit ceiling it should be adjusted within the 

next month. To achieve this goal, the central bank needs to implement monetary instruments, forecast the monetary 

                                                             
4 Foreign exchange obligation account was established in 1993 to compensate the importers for the difference of the unified 
exchange rate with the nominal exchange rate. 



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aggregates, and find out the relationship between the general price level and the allocated credits. In doing so, the 

central bank needs a monetary model to evaluate the stance of monetary policy. Such a model will be presented in 

the next section to forecast the inflation rate and to evaluate the trade-off between inflation targeting and the real 

output.   

Most of the empirical studies that have been carried out for Iran (Komijani and Bidabad 1999) suggest that the 

supply side factors or cost-push inflation have lower effects on the CPI inflation than demand-push factors. Indeed, 

according to the empirical studies, 99% of the changes in CPI, in the long run, can be explained by the money 

supply. In other words, these studies suggest that inflation in Iran is a monetary phenomenon. Therefore, the most 

appropriate way to control inflation is through money supply. Moreover, the monetary transmission mechanism of 

the real sector is trivial. Any change in the money supply has negligible effects on the interest rate and investment 
due to administered interest rates. All in all, one can argue that any decrease in the money supply will not affect the 

real sector of the economy in the long-run. 

Concerning the monetary policy stance, it has historically been dominated by fiscal policy. Therefore, inflation 

targeting will be a more appropriate instrument to conduct the monetary policy with a consensus between the 
monetary authorities, government, and the public. Indeed, the pragmatic argument for inflation targeting begins with 

the proposition that, from a long-run point of view, monetary policy has a dominating influence on an economy's 

inflation rate and negligible influence on its rate of unemployment and output. This proposition, which is an 

interpretation of the natural rate hypothesis, is supported by the empirical results, as will be seen in the next section. 

4. Monetary model:  

The rationale for inflation targeting emerges as the joint consequences of two lines of thoughts within the economics 

of monetary policy. First, because the central bank in effect has only one instrument at its disposal, the standard 
Tinbergen-Theil logic implies that it is possible to express the policy chosen at any time in terms of the intended 

outcome of any single economic magnitude that monetary policy affects: inflation, output, employment, the 

economy's foreign balance.  

The second line of thought within the field that underlies the concept of inflation targeting is the Phelps-Friedman 
"natural rate" model of aggregate supply in the market for goods and services. Under the most familiar version of the 

natural rate model, there exists a trade-off between real outcomes like output and employment and nominal outcomes 

like inflation and prices. By contrast, in the long run, there is no evidence to support such a trade-off; long-run real 

outcomes depend on such real factors as endowments, technologies, and etc. In the long run, nominal magnitudes are 

subject to monetary influences. Indeed, aggregate shocks that move output and inflation in opposite directions create a 

trade-off between output and inflation variability, forcing the central bankers to make a choice.  

In this section, we present a very simple monetary model according to the monetarists' view. The following flow 

chart presents the relationship between the main variables of the model. As it is seen, the liquidity is decomposed to 

the net domestic assets and net foreign assets of the banking system. The net foreign asset component is affected by 

the official exchange rate and the balance of payments. The net domestic assets consist of three components: private 

sector debt to the banking system, government debt to the banking system, and net of other assets. The private sector 

debt to the banking system is affected by gross domestic product (GDP). The government debt to the banking 

system is influenced by the government budget deficit and foreign exchange obligations account. The price level is 

defined as a function of liquidity. Change in GDP is affected by the balance of payments. The estimated results are 

presented in the following section, and the econometric model is estimated by OLS technique. The sample period 

covers 1960-2001. To avoid integration problems, all level variables are used in their first differences.  

List of variables:- 

M2NFAE=Net foreign assets of the banking system (in billion dollars) 

M2NGV=Net government debt to the banking system (in billion Rials) 

M2LPV=Net Private sector debt to the banking system (in billion Rials) 

M2NW=Other assets of the banking system (in billion Rials) 

OBD=Government budget deficit (in billion Rials) 



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BOP=Balance of payments (million dollars) 

FEOA=Foreign exchange obligation account (in billion Rials) 

GDPV=Nominal GDP (in billion Rials) 

GDP=Gross Domestic Production at fixed prices of 1982 (in billion Rials) 

PGDP=GDP deflator (base year=1982) 

M2 = Liquidity (in billion Rials) 

E = Exchange rate 

D61 = Dummy variable, one for 1982 and zero otherwise 

D69 = Dummy variable, one for 1990 and zero otherwise 

D72 = Dummy variable, one for 1993 and zero otherwise 

D5873=Dummy variable, one for 1994-95 and zero otherwise 

D = Difference operator  

@Trend = Time trend 

 

The following system of equations was estimated. 

 

D(M2NFAE) = C(11)*BOP/1000+C(12)*D72+C(13)*D69+C(14)*D60+c(15)*D7680  

D(M2NGV) = C(20)+ C(21)*OBD +C(22)*OL +D(FEOA) +C(23)*D79 +C(24)*D80 

D(M2LPV) = C(31)*D(GDPV)+C(32)*D80 

D(M2NW) =  C(41)*D7780+C(42)*D79+C(43)*D80+C(44)*@TREND 

D(PGDP) = C(51)*D(M2) +C(52)*D80 

D(GDP) =C(60)+C(61)*BOP/1000+ C(62)*D(GDP(-1))+C(63)*D5659 +C(64)*D65 +C(65)*D55 

M2 = M2NFAE * E + (M2NGV + M2LPV + M2NW) 

GDPV = GDP * PGDP 

 



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Flowchart (1). Relationship between the main variables of the monetary model 

 

 

====================================================== 

System: SYS_INF                                                        

Estimation Method: Least Squares                                       

Sample: 1339 1380                                                      

Included observations: 42                                              

Total system (unbalanced) observations 251                             

====================================================== 

                    Coefficient    Std. Error  t-Statistic  Prob.             

====================================================== 

      C(11)          0.914673   0.097201   9.410124   0.0000           

      C(12)         -21.40064   1.346235  -15.89666   0.0000           

Real GDP 

Nominal 

GDP 

Official 

exchange rate 

Liquidity 

M2 

Price level 

Balance of 

payments 

Net foreign assets of 

banking system 

Net domestic assets of 

banking system 

Changes in other assets 

of the banking system 
Net other 

assets 

Net gov debt to 

banking system 

Net private debt to 

banking system 

Government 

budget deficit 

Foreign exchange 

obligation account 

Changes in previous 

real GDP 



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      C(13)          9.443943   1.346362   7.014414   0.0000           

      C(14)          5.263224   1.367823   3.847885   0.0002           

      C(15)         -2.368778   0.621046  -3.814173   0.0002           

      C(20)         -274.1686   167.8247  -1.633661   0.1037           

      C(21)          1.257852   0.055344   22.72777   0.0000           

      C(22)          0.219124   0.027767   7.891556   0.0000           

      C(23)         -14060.40   975.8079  -14.40899   0.0000           

      C(24)          11626.61   962.0447   12.08531   0.0000           

      C(31)          0.309446   0.012301   25.15634   0.0000           

      C(32)          33424.48   2846.179   11.74363   0.0000           

      C(41)         -12933.99   598.0382  -21.62736   0.0000           

      C(42)          29662.57   960.1021   30.89523   0.0000           

      C(43)          4877.350   960.1694   5.079677   0.0000           

      C(44)         -15.28007   5.684013  -2.688254   0.0077           

      C(51)          7.03E-06   2.96E-07   23.79357   0.0000           

      C(52)         -0.294803   0.032899  -8.960742   0.0000           

      C(60)          6249.474   1531.646   4.080234   0.0001           

      C(61)          1354.759   568.7077   2.382171   0.0180           

      C(62)          0.368434   0.093348   3.946897   0.0001           

      C(63)         -23153.95   4256.940  -5.439107   0.0000           

      C(64)         -26557.75   8121.092  -3.270219   0.0012           

      C(65)          23064.76   8199.437   2.812969   0.0053           

====================================================== 

Determinant residual covariance 5.51E+22                               

====================================================== 

Equation: D(M2NFAE) = C(11)*BOP/1000+C(12)*D72+C(13)*D69 +C(14)*D60+C(15)*D7680                                  

Observations: 42                                                       

R-squared            0.913271    Mean dependent var 0.132592           

Adjusted R-squared   0.903895    S.D. dependent var 4.341973           

S.E. of regression   1.346047    Sum squared resid  67.03814           

Durbin-Watson stat   2.147208                                          

Equation: D(M2NGV) = C(20)+ C(21)*OBD +C(22)*OL+D(FEOA)+C(23) *D79+C(24)*D80                                                

Observations: 42                                                       



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R-squared            0.971197    Mean dependent var 2320.165           

Adjusted R-squared   0.968084    S.D. dependent var 5260.589           

S.E. of regression   939.8117    Sum squared resid  32680103           

Durbin-Watson stat   2.238885                                          

Equation: D(M2LPV) = C(31)*D(GDPV)+C(32)*D80                           

Observations: 42                                                       

R-squared            0.960945    Mean dependent var 5773.873           

Adjusted R-squared   0.959969    S.D. dependent var 13071.46           

S.E. of regression   2615.321    Sum squared resid  2.74E+08           

Durbin-Watson stat   1.049681                                          

Equation: D(M2NW) =  C(41)*D7780+C(42)*D79+C(43)*D80+C(44) *@TREND 

Observations: 42                                                       

R-squared            0.967070    Mean dependent var-692.9867           

Adjusted R-squared   0.964470    S.D. dependent var 4158.716           

S.E. of regression   783.8891    Sum squared resid  23350323           

Durbin-Watson stat   3.436861                                          

Equation: D(PGDP) = C(51)*D(M2) +C(52)*D80                             

Observations: 42                                                       

R-squared            0.923764    Mean dependent var 0.047743           

Adjusted R-squared   0.921858    S.D. dependent var 0.089887           

S.E. of regression   0.025127    Sum squared resid  0.025254           

Durbin-Watson stat   2.826425                                          

Equation: D(GDP)=C(60)+C(61)*BOP/1000+C(62)*D(GDP(-1))+C(63) *D5659+C(64)*D65 +C(65)*D55 

Observations: 41                                                       

R-squared            0.706315    Mean dependent var 6893.122           

Adjusted R-squared   0.664359    S.D. dependent var 13732.14           

S.E. of regression   7955.646    Sum squared resid 2.22E+09           

Durbin-Watson stat   1.521260                                          

====================================================== 

 

 

 



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Graph 1 Plot of residuals of estimated equations 

 

As it is seen in the estimated results, the net foreign assets of the banking system has a positive significant 

relationship with the balance of payments. The coefficient on C(21) is positive and significant, supporting a positive 

link between the government budget deficit and the government debt to the banking system. The coefficient on 

C(22) is also positive and significant, representing a relationship between the obligation loans and the government 

debt to the banking system. Interestingly enough, foreign exchange obligation account has a one to one relationship 

with the net government debt to the banking system. 

 

-3

-2

-1

0

1

2

3

4

40 45 50 55 60 65 70 75 80

M2NFAE Residuals

-5000

-4000

-3000

-2000

-1000

0

1000

2000

3000

4000

40 45 50 55 60 65 70 75 80

M2NGV Residuals

-12000

-8000

-4000

0

4000

8000

12000

40 45 50 55 60 65 70 75 80

M2LPV Residuals

-3000

-2000

-1000

0

1000

2000

3000

40 45 50 55 60 65 70 75 80

M2NW Residuals

-.12

-.08

-.04

.00

.04

.08

.12

40 45 50 55 60 65 70 75 80

PGDP Residuals

-20000

-10000

0

10000

20000

40 45 50 55 60 65 70 75 80

GDP Residuals



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Equation (5) suggests that nominal GDP is positively and significantly related to the liquidity, supporting the 

monetarists' view. In other words, any change in the money supply will affect the nominal GDP. In addition, net 

private sector debt to the banking system is positively and significantly correlated with nominal GDP. Equation (6) 

suggests that real GDP at fixed prices is positively and significantly related to the BOP. 

To evaluate the performance of the model, we solved the whole system for the whole ex-post sample period through 

dynamic simulation. Graph 2 plots the actual value of the endogenous variables versus their simulated values. The 8 

plots of Graph 1 show the high dynamic response and credibility of the model to build simulated series as near as the 

actual series with a concordance of turning points. 

Graph 2 Simulated versus actual values of the endogenous variables in the dynamic solution 

 

 

-15

-10

-5

0

5

10

15

20

25

40 45 50 55 60 65 70 75 80 85

Actual M2NFAE (Scenario 1)

M2NFAE

-40000

-30000

-20000

-10000

0

40 45 50 55 60 65 70 75 80 85

Actual M2NW (Scenario 1)

M2NW

-20000

0

20000

40000

60000

80000

100000

40 45 50 55 60 65 70 75 80 85

Actual M2NGV (Scenario 1)

M2NGV

-50000

0

50000

100000

150000

200000

250000

40 45 50 55 60 65 70 75 80 85

Actual M2LPV (Scenario 1)

M2LPV



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Graph 2 (Cont.) Simulated versus actual values of the endogenous variables in the dynamic solution 

 

5. Conclusion 

As the estimated results in the previous section suggest, inflation targeting in Iran does not affect the real output in 

the long run. Indeed, monetary transmission policy affects the general price level, leaving trivial effects on the real 

output. Therefore, one can argue that there is no trade-off between inflation targeting and the real output, supporting 

the notion of the natural rate hypothesis. 

One of the main findings of this study is that major problem in achieving inflation targets in the Iranian economy is 

the lack of transparency and credibility of the target due to fiscal situation, institutional set up for the monetary 

policy, and ineffectiveness of monetary instruments. Indeed, as the experiences of other countries suggest fiscal 

discipline has a crucial role in the success of inflation targeting.  

Moreover, the inflation target lacks credibility in Iran, in the sense that inflation expectations exceed the target 

range. Reduction of the real budget deficit through reducing the foreign exchange obligation account might restore 

the credibility of the government and monetary authorities.    

Imperfect credibility has several detrimental consequences. First, imperfect credibility makes it more costly and 

more difficult to achieve the target. Monetary policy has to be more contractionary to counter the inflationary 

impulses that inflation expectation causes.  

 

-50000

0

50000

100000

150000

200000

250000

300000

350000

40 45 50 55 60 65 70 75 80 85

Actual M2 (Scenario 1)

M2

-0.4

0.0

0.4

0.8

1.2

1.6

2.0

2.4

40 45 50 55 60 65 70 75 80 85

Actual PGDP (Scenario 1)

PGDP

-100000

0

100000

200000

300000

400000

500000

600000

700000

40 45 50 55 60 65 70 75 80 85

Actual GDPV (Scenario 1)

GDPV

40000

80000

120000

160000

200000

240000

280000

320000

360000

40 45 50 55 60 65 70 75 80 85

Actual GDP (Scenario 1)

GDP



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Second, imperfect credibility most likely allows less scope for short-run stabilization of unemployment. Any attempt 

to temporarily pursue a more expansionary policy in order to reduce temporarily high unemployment will probably 

be interpreted as increased tolerance towards medium and long-run inflation, and hence induce a further fall in 

already low credibility, with increased inflation expectations and increased medium and long-term interest rates, as a 

result. The increased inflation expectation is also likely to result in faster nominal wage and price adjustment, which 

reduces the real effect of a given monetary expansion.  

Indeed, the government and the parliament in their attempts to expand the credibility of the system should reduce 

their incentives to create inflation by strengthening price stability as a goal for monetary policy. In doing so, the 

government and the parliament can achieve fiscal consolidation by eliminating partial de-indexing of expenditures 

and taxes. The most crucial challenge that the central bank should overcome is to remedy the credibility problem 
through pursuing a monetary policy that fulfills the inflation targets. The central bank can increase its commitment 

by a policy statement that clarifies that inflation targets will be strictly in effect for the whole third plan.    

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