An Analysis of Monetary Policy in Iran

This thesis provides an analysis of monetary policy, source of inflation and potential adoption of inflation targeting in Iran. In particular, the conduct of current monetary policy and the source of inflation in Iran presented in Chapter 2. Chapter 3 investigates the concept of inflation targeting and its specification as well as the prerequisites that should be met by an economy in order to move to inflation targeting strategy. Since a Taylor-type rule it is not a theory-based rule, a model is derived by optimising the monetary authority’s loss function. In order to express the significant role of the variation of the exchange rate on a monetary policy, Chapter 4 derives a theory based central bank reaction function which explicitly includes the exchange rate gap and is empirically tested. The hypothesis of ignoring the fluctuation of exchange rate is rejected. One of the vital elements in success of inflation targeting framework, is the accuracy of the predicted inflation rate from the central bank. After evaluating the P-star model as a representative instrument for forecasting inflation in chapter 5, different measures of velocity, have been evaluated. After structural break test on data and stationarity tests, a VAR has been constructed and the concluding VECM is estimated. From the results of the exogeniety test, the P-star model can be used as an appropriate tool in forecasting inflation in Iran. This thesis contributes to the literature in three aspects. Firstly, a micro-based model of the monetary policy reaction function is derived which considers the target of the inflation explicitly. Secondly, it recommends a practical formation of monetary policy to include exchange rate fluctuations in the reaction function of the Central Bank of Iran and finally, investigates the effectiveness of the P-star model in predicting inflation in Iran.