Testing The Phillips Curve Hypothesis In Post-Revolution Iran

Abstract

In this paper, we test the Phillips Curve hypothesis in the Islamic Republic of Iran, where economic conditions have deteriorated because of double-digit inflation rates and rising unemployment rates. Within this context, high values of the Misery Index signify worsening living conditions as a combination of rapid inflation and rising unemployment makes the average citizen cross the economic line into poverty. Analyzing annual data for the period of 1980-2015 indicates that stagflationary conditions have prevailed with double-digit inflation and unemployment rates. In particular, inflationary pressures have been rampant and volatile with a mean of 21.3 percent and a standard deviation of 8.2 percent. Meanwhile, the labor force has experienced chronic unemployment. In the period of this study, the unemployment rate had a mean of 13.5 percent and a standard deviation of 2.1 percent. The Misery Index averaged 34.8 percent with a standard deviation of 7.5 percent. Our estimation results of the Phillips Curve identify a significant trade-off between inflation and unemployment rates, where inflationary expectations are formed both adaptively and rationally. We also find that this trade-off intensifies with involvement in external conflict as resources are diverted from civilian production to military pursuit in an already volatile region of the Middle East (e.g., Iraq, Syria, and Yemen). All being equal, we estimate the cost of reducing unemployment rate by one percent is a two-percent rise in the rate of inflation. We also discover that engagement in external conflict accelerates inflation, but helps ease unemployment. Conversely, we uncover that lifting international sanctions to help ease inflation would add to the already high unemployment. Taking these results into consideration, the key to Iran's economic stability is to construct a peaceful environment in which petro-dollars are reverted to civilian production. Then, economic and banking reforms will be necessary to expand productive capacity and creae meaningful jobs, boosting the supply of consumer and capital goods to relieve inflationary pressures. Such reforms of curbing inflation and creating jobs are better achieved under a democratic government, advocating a market-oriented system.