Oil price cycles, fiscal dominance and countercyclical monetary policy in Iran

Abstract

AbstractThe mission of monetary policy is to conduct countercyclical policy, however, this is not a universally practiced norm. Pro‐cyclical fiscal and monetary policies during boom periods have often been observed in developing countries and tend to amplify the impact of positive commodity price shocks. The consequence is strengthening of domestic inflationary pressures and appreciation of the exchange rate. This paper examines counter‐cyclicality of monetary policy and the role of fiscal policy in this regard. The stance of fiscal policy and the manner of financing government expenditures have a significant effect on the conduct of monetary policy. Our empirical observations indicate that, fiscal and monetary policies in Iran are generally expansionary, particularly during economic booms, often resulting in subsequent large depreciation of the domestic currency followed by higher inflation rates and economic slowdown. Under fiscal dominance, monetary policy is ineffective and both targets and instruments of monetary policy will not be under the control of the central bank. A structurally balanced fiscal rule that maintains an aligned exchange rate allows effective countercyclical monetary policies and discourages excessive foreign financing. Moreover, policy measures that increase more reliance on domestic resources are the appropriate policy measures that makes the economy more resistant to external shocks.