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

• Author: Mohammad Amin Naderian,Ahmad Reza Jalali Naini
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/opec.12125
• Published date: 01 March 2019

Oil price cycles, fiscal dominance and

countercyclical monetary policy in Iran

Ahmad Reza Jalali Naini* and Mohammad Amin Naderian**

*Associate professor, Institute for Management and Planning Studies (IMPS), No.6, Shahid Mokhtar

Asgari, Jamal Abad, Tehran 1978911114, Iran. Email: a.jalali@imps.ac.ir

**Senior oil market analyst, Ministry of Petroleum, Tehran, Iran. Email: ma.naderian@mop.ir

Abstract

The 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.

1. Introduction

The classic mission of monetary policy is to provide price stability and to operate as an

anti-cyclical stabilizing force over the business cycles by choosing an appropriate

nominal anchor to conduct policy. What is the suitable nominal anchor for the economy?

That depends on the structure of the economy and the development of the financial

markets. Until the early 1980s, money supply was largely recognized to be the nominal

anchor and the primary task of monetary policy was to target its rate of growth. In the

simpler versions of this scheme, money supply was conceived to be an exogenously

determined policy variable. In their joint work Friedman and Schwartz (1963) suggested

JEL classification: E52, E63.

©2018 Organization of the Petroleum Exporting Countries. Published by John Wiley & Sons Ltd, 9600 Garsington

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3

that the cause of inflation is excessive growth of the money supply. Deceleration of both,

the rate of inflation and nominal-GNP growth rate occurs subsequent to prior money

growth deceleration. Moreover, occurrence of a recession (depression) and deflation can

be traced back to prior contractionary monetary policy in a period of credit restriction or

credit crunch. Empirical observations cited in Friedman and Schwartz’s study paved the

way for a more general policy question: the choice between rules versus discretion as

alternative ways to conduct monetary policy. Friedman’skper cent rule stipulated a

long-run policy induced growth rate of monetary base. If, projected (average) GDP

growth is hper cent and the (average) money supply is allowed to grow at k per cent, and

if the income elasticity of demand for money is unity the inflation rate on average will be

khper cent.

1

Several criticisms have been levelled against the k-per cent rule. Obstfeld and Rogoff

(1983) argue that the desired amount of money a representative household keeps is

subject to inflation expectations. In other words, the demand for money reacts to changes

in expectations hence there exist different equilibrium inflation trajectories. This line of

argument questions whether control of the money supply is sufficient to determine the

equilibrium inflation path. Bernanke and Blinder (1987) argue against a fixed rule by

comparing it to fixing a rudder in a stormy sea. McCallum (1987) and Meltzer (1987)

contend that the monetary policy rule should consider and adjust for financial disorders

and innovations, which allows for some flexibility while maintaining a pre-commitment

to the announced policy rule. McCallum (1987) is an example of a quantitative money

rule which is more flexible than the kper cent rule but adheres to a policy stance.

Moreover, Mc Cullum’s rule can be differentiated with kper cent rule in that it is also a

feed-back rule like Taylor (1999).

2

These feedback rules endogenize the monetary policy

instrument, usually a short-term interest rate, with respect to the state variables to attain

the targets for monetary policy. The New Keynesian model provides a suitable

framework for optimal feedback rules. In contrast with simple instrument rules, this

modelling approach is based on a policy loss function specified in terms of the targeted

policy variables that yields a targeting rule which can be used to derive the optimal

policy reaction function of the central bank.

3

In this context the central bank sets the

policy rate as a function of inflation and output gap in line with their anti-cyclical (or

stabilization) objectives.

4

The prevalent tradition in the New-Keynesian as well as the broader literature has

been to model inflation and its trajectory over time by focusing on monetary policy and

leave aside fiscal policy. The standard New-Keynesian inflation targeting models often

do not contain the effect of government budget and the path of the public debt. In this

setup, the consequence of monetary policy decisions on the fiscal side and vice-versa is

omitted. This assumption might be harmless for an economy that can sufficiently raise

non-distortive revenues to finance expenditures but it may not be suitable for those

OPEC Energy Review March 2019 ©2018 Organization of the Petroleum Exporting Countries

4Ahmad Reza Jalali Naini and Mohammad Amin Naderian