1. 16th Conference on Monetary and Foreign Exchange Policies Tehran, May 16-17, 2006 Monetary Policy in Iran: The Challenge of Reducing Inflation * Leo Bonato and Abdelali Jbili (IMF) * This paper should not be reported as representing the views of the IMF.The views expressed in this paper are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

2. International Monetary Fund2 Roadmap Motivation Monetary policy assessment Consistency of macroeconomic policies Costs of the current situation Conclusions and policy recommendations

3. International Monetary Fund3 Motivation I.R. of Iran: relatively high inflation for more than 30 years Increased awareness of the need to reduce it: –Global inflation decline –Conflict with economic integration, competitiveness, long-term growth Is the policy setting consistent with this need?

4. International Monetary Fund4 Monetary policy assessment A word of caution: effectiveness of monetary policy depends on a number of factors: –Lack of fiscal dominance –Clear and limited objectives –Effective instruments

5. International Monetary Fund5 Monetary policy assessment Influences on inflation: lessons from theory –Money: differences between long-run and short-run –Exchange rate: pass-through reflects trade openness, expectations, and impacts on money demand

6. International Monetary Fund6 Monetary policy assessment IMF research –Liu and Adedeji (2000): long-term equilibrium conditions, strong impact of money on inflation, low ER effect –Celasun and Goswami (2002): real money demand function, strong impact of money on inflation, high ER effect –Kramarenko (2004b): inverted money demand function, one-to-one relationship money/inflation, high ER pass-through

7. International Monetary Fund7 Monetary policy assessment FYDPs: implicitely recognize link money/inflation with targets for both FFYDP (1989/90-1993/94) –Inflation: target exceeded by 4 percent on average –M2: target exceeded by 16 percent on average SFYDPS (1995/96-1999-2000): –Inflation: target exceeded by 14 percent on average –M2: target exceeded by 13 percent on average

8. International Monetary Fund8 Monetary policy assessment

9. International Monetary Fund9 Monetary policy assessment

10. International Monetary Fund10 Monetary policy assessment Overall inflation performance not satisfactory –TFYDPs: some improvement, partly due to exchange rate appreciation; but not sufficient No trend decline Subsidies and price freezes –Systematic breach of monetary targets has continued

11. International Monetary Fund11 Consistency of macroeconomic policies New setting: unification of exchange rates (2001/02) Managed float Monetary targeting Challenges: –Oil revenues and fiscal policy: growth and employment objectives –Exchange rate: downward drift –Limited instruments to control liquidity –Weak anti-inflation mandate

12. International Monetary Fund12 Consistency of macroeconomic policies

13. International Monetary Fund13 Consistency of macroeconomic policies Fiscal dominance –Net financing of government is limited, but spending out of dollar oil revenues results in large injections of high-powered money very difficult to sterilize due to their size Exchange rate management –concerns about competitiveness lead to depreciation, adding 1 percent to inflation every year

14. International Monetary Fund14 Consistency of macroeconomic policies Weak monetary instruments –Rates of return set by MCC in a way that is not necessarily consistent with monetary policy needs – CBPPs introduced in 2001: issues are far too small, not sufficiently flexible (need parliament authorization) Institutional setting –Too many objectives (Art 10(b) of Monetary and Banking Law) and too little autonomy

15. International Monetary Fund15 Cost of the current situation Cost/benefit analysis of disinflation –Costs: temporary loss in output, employment –Benefits: permanent elimination of inflation costs Inefficient allocation of resources Increased distortions (e.g. nominal income taxation) Underdeveloped financial system Disproportionate impact on poor Growth (Khan and Senhadji, 2001; Bailén, 2004)

16. International Monetary Fund16 Cost of the current situation Long-run money neutrality: monetary cannot affect output and employment permanently Natural rate theory: no trade-off between inflation and output in the long run Competitiveness is a real variable: cannot be permanently affected by monetary policy Conclusions: the best contribution monetary policy can give is to reduce inflation

17. International Monetary Fund17 Conclusions and policy recommendations Fiscal policy –Employment objective very important –Room to tighten by cutting expenditure: energy subsidies –Fiscal guidelines to reduce procyclicality and vulnerability to oil prices –Coordination with monetary policy: monetary impact of fiscal policy decisions should be incorporated in macroeconomic framework, to be revised annually –More spending implies higher real exchange rate appreciation

18. International Monetary Fund18 Conclusions and policy recommendations Monetary instruments –All decisions about monetary instruments (rates of return, CBPPs issues and rates of returns) should be left to the CBI –Development of new instruments would be helpful (Kramarenko, 2004a) Monetary policy mandate –Clear priority to inflation –Exchange rate consideration fully subordinated –Monetary targeting appropriate if stable money demand