I. Government’s Budgetary Policy and Its Impact on Money Supply

Because of limited sources of financing in many of the developing countries, changes in the budget deficit are, to a large extent, reflected in changes in the rate of monetary creation. Even a balanced budget, however, can lead to monetary expansion when a large proportion of government revenues are in foreign exchange, that is, oil revenues. Unlike domestic taxes, foreign revenues in the form of royalties on natural resources do not induce a reduction in disposable income, and their domestic spending leads to the creation of additional money. In this case, the contribution of the budget to the monetary expansion is best measured by the Government’s domestic deficit, defined as the difference between the domestic expenditure DE and domestic revenue DR.⁴ The change in the money supply M can then be written according to the following identity when PEX and PIM denote the private sector’s exports and imports and C denotes the flow of credit to the private sector from the domestic banking system and from external sources (that is, private capital inflows).

The breakdown of the Government’s total expenditure into domestic and foreign components is not readily available. The above identity is therefore rewritten as follows, when GE denotes total government expenditure and IM denotes total imports (government plus private imports).

The Government is assumed to have planned its expenditures on the basis of a balanced budget policy; that is, in the long run, the authorities desired to spend all of the available revenues. In the short run, however, expenditures were adjusted, with a lag, to any abrupt changes in revenues. Government expenditures were therefore determined according to the following relationship, when GR denotes the Government’s total revenues.

Rearranging terms results in equation (4).

Government revenues were composed of oil revenues OR and domestic revenues DR.

Oil revenues were determined exogenously according to official prices of oil and production levels. The Government derived its domestic revenues from direct taxes on income and property and indirect taxes on trade. These taxes were generally adjusted in line with the increase in income although as a result of various institutional and administrative factors the adjustment took place with a lag.⁵ The adjustment of the domestic revenues is specified as follows.

Rearranging terms results in equation (7).

II. Sources of Domestic Inflation

The domestic price level P is a weighted average of the price of traded goods P^t and the price of nontraded goods Pⁿ.

We assume that the price of traded goods is determined exogenously in the world markets while the price of nontraded goods adjusts to equilibrate the domestic market according to the following adjustment mechanism, when (M/P) denotes the actual level of real money balances and m^* the desired level.

Equation (9) indicates that first, any excess supply of money increases the pressure on the price of nontraded goods; and second, any rise in the price of traded goods leads to a rise in the price of nontraded goods, as it increases the demand for and reduces the supply of nontraded goods.

The desired demand for real money balances,m^* is specified as a simple function of income when a denotes the income elasticity.

Substituting m^* from equation (10) in equation (9) and rearranging terms results in

III. Private Expenditure and Income Determination

Private expenditure E is specified in real terms as a function of income and excess supply of real money balances.

In this monetary version of the expenditure function, an excess supply of money directly affects real expenditure, in contrast to a Keynesian version, in which an excess supply of money affects expenditure through the interest rate channel.⁶ Substituting m^* from equation (10) and rearranging terms results in

Domestic output Y is determined according to the following identity:

It should be noted that we have included only private exports and excluded oil exports from our definition of income. For national accounting purposes, oil revenues should clearly be included in any definition of gross national product. However, insofar as oil exports have negligible domestic value added, they do not contribute directly to the income of the domestic residents until they are spent by the Government. Thus, oil revenues that are not spent by the Government are excluded from our definition of income because they have no effect on the behavioral relationships of our model, which is designed to capture the behavior of the non-oil economy.

IV. Demand for Imports

As already mentioned, import data for the Government and the private sector are not separately available. Demand for total imports is therefore specified as a function of government expenditures and private expenditures. In addition, the terms of trade between imports and domestic goods (P^t/Pⁿ) are also included to capture the impact of relative prices on the demand for the volume of imports.

The above formulation is basically along the lines suggested by the literature on “The Monetary Approach to the Balance of Payments” in the sense that any excess supply of, or demand for, money is partly satisfied through the adjustment of private expenditure and, consequently, imports,⁷ In this framework, any increase in government expenditures resulting from higher oil revenues affects imports through three channels. First, government expenditure on foreign goods increases imports directly. Second, government expenditure on nontraded goods results in an expansion of money supply, leading to an increase in private expenditures on all goods including imports. Third, higher private expenditure leads to higher nontraded prices, further increasing the demand for imports.

V. Estimation Results

The complete model is composed of six behavioral equations and three identities,⁸ determining nine endogenous variables. The model was estimated for the period 1960-77, using an ordinary least-squares method.⁹ The list of variables is provided in Table 1. The estimated equations are provided in Table 2, where the t-values are given in parentheses underneath the coefficient.¹⁰

Although preliminary, the empirical results are quite encouraging. All the coefficients of the model have the correct sign and, with only one exception, they are significant at 0.05 confidence level.¹¹ The structural equations predict the behavior of the endogenous variables well, as indicated by the relatively high values of the R ² coefficient.

The estimation of government expenditures indicates that these expenditures were adjusted in line with the increase in total revenues, such that the budget was balanced over the longer term.¹² The adjustment coefficient γ is about 0.62, which indicates that the mean lag of adjustment—the period required for about 63 percent of any disequilibrium between actual and desired expenditures to be eliminated—was about seven months.¹³ The estimation of government revenues indicates that non-oil revenues responded with a lag to the rise in income. The mean lag of response was about eight months, which was somewhat longer than the mean lag of government expenditures.

Table 1.

List of Variables

¹This index was calculated as a weighted average of trading countries’ export price indices, adjusted for exchange rates.

Table 1.

List of Variables

Variable	Definition
	Endogenous variables
M	Money supply (broad definition)
GE	Government expenditure
GR	Government total revenue
DR	Government domestic revenue
P	Domestic prices (CPI)
Pn	Price of nontraded goods
E	Private expenditure
γ	Domestic real income (non-oil)
IM	Imports
	Exogenous variables
PEX	Private exports (non-oil)
C	Changes in credit to the private sector from the banking system and external sources
OR	Government oil revenues
Pt	Price of traded goods1

¹This index was calculated as a weighted average of trading countries’ export price indices, adjusted for exchange rates.

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Table 1.

List of Variables

Variable	Definition
	Endogenous variables
M	Money supply (broad definition)
GE	Government expenditure
GR	Government total revenue
DR	Government domestic revenue
P	Domestic prices (CPI)
Pn	Price of nontraded goods
E	Private expenditure
γ	Domestic real income (non-oil)
IM	Imports
	Exogenous variables
PEX	Private exports (non-oil)
C	Changes in credit to the private sector from the banking system and external sources
OR	Government oil revenues
Pt	Price of traded goods1

¹This index was calculated as a weighted average of trading countries’ export price indices, adjusted for exchange rates.

The estimation of the domestic price level indicates that the weight of nontraded goods in the consumer price index is about one half.¹⁴ The estimation of the price changes of nontraded goods indicates that the monetary factors significantly contributed to the increase in the price of these goods. The changes in the price of imports also had a significant effect on the changes in the price of nontraded goods. The income elasticity of the demand for money, a, calculated from this equation is about 1.2.

Table 2.

Estimated Model

¹Corrected for autocorrelation.

Table 2.

Estimated Model

Item	Estimated Equation
Government expenditures	$\begin{array}{cc}G{E}_t=& \underset{(0.8)}{8.0}+\underset{(13.0)}{0.69}G{R}_t+\underset{(6.6)}{0.44}G{E}_{t-1}\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& h=0.56\end{array}\end{array}$
Government domestic revenues1	$\begin{array}{cc}D{R}_t=& -\underset{(4.4)}{16.6}+\underset{(5.3)}{0.12}Y{P}_t+\underset{(2.2)}{0.40}D{R}_{t-1}\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& h=0.62\end{array}\end{array}$
Domestic price level1	$\begin{array}{cc}ln{P}_t=& \underset{\left(0.3\right)}{0.01}+\underset{\left(7.3\right)}{0.53}ln{P}_t^n+\underset{\left(7.6\right)}{0.52}ln{P}_t^t\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& DW={1.48}^1\end{array}\end{array}$
Price changes of nontraded goods1	$\begin{array}{c}\begin{array}{cc}\mathrm{\Delta }\ln P_t^n=& \underset{(1.7)}{1.16}+\underset{\left(2.4\right)}{0.37}\ln {(M/P)}_{t-1}\\ & -\underset{(2.1)}{0.45\ln }{Y}_t+\underset{(3.6)}{0.60}\ln {(P^t/P^n)}_{t-1}\end{array}\\ \begin{array}{cc}{R}^2=0.64& DW={1.87}^1\end{array}\end{array}$
Real private expenditures	$\begin{array}{c}\begin{array}{cc}\ln {(E/P)}_t=& \underset{(4.6)}{3.06}+\underset{(2.8)}{0.43}\ln {(M/P)}_{t-1}\\ & -\underset{(0.8)}{0.18}\ln Y_t\end{array}\\ \begin{array}{cc}\begin{array}{c}{R}^2=0.98\end{array}& DW=1.95\end{array}\end{array}$
Volume of imports	$\begin{array}{c}\begin{array}{cc}\ln {(IM/P^t)}_t=& \underset{\left(4.1\right)}{4.26}+\underset{\left(7.6\right)}{0.63}\ln {(GE/P)}_t\\ & +\underset{(4.7)}{0.89}\ln {(E/P)}_t\\ & -\underset{(1.1)}{0.83}\ln {(P^t/P^n)}_{t-1}\end{array}\\ \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& DW=1.48\end{array}\end{array}$
Income identity	Y = (E + GE + PEX - IM)/P
Money supply identity	ΔM = GE - GDR + PEX - IM + C
Budget identity	GR = DR + OR.

¹Corrected for autocorrelation.

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Table 2.

Estimated Model

Item	Estimated Equation
Government expenditures	$\begin{array}{cc}G{E}_t=& \underset{(0.8)}{8.0}+\underset{(13.0)}{0.69}G{R}_t+\underset{(6.6)}{0.44}G{E}_{t-1}\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& h=0.56\end{array}\end{array}$
Government domestic revenues1	$\begin{array}{cc}D{R}_t=& -\underset{(4.4)}{16.6}+\underset{(5.3)}{0.12}Y{P}_t+\underset{(2.2)}{0.40}D{R}_{t-1}\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& h=0.62\end{array}\end{array}$
Domestic price level1	$\begin{array}{cc}ln{P}_t=& \underset{\left(0.3\right)}{0.01}+\underset{\left(7.3\right)}{0.53}ln{P}_t^n+\underset{\left(7.6\right)}{0.52}ln{P}_t^t\\ & \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& DW={1.48}^1\end{array}\end{array}$
Price changes of nontraded goods1	$\begin{array}{c}\begin{array}{cc}\mathrm{\Delta }\ln P_t^n=& \underset{(1.7)}{1.16}+\underset{\left(2.4\right)}{0.37}\ln {(M/P)}_{t-1}\\ & -\underset{(2.1)}{0.45\ln }{Y}_t+\underset{(3.6)}{0.60}\ln {(P^t/P^n)}_{t-1}\end{array}\\ \begin{array}{cc}{R}^2=0.64& DW={1.87}^1\end{array}\end{array}$
Real private expenditures	$\begin{array}{c}\begin{array}{cc}\ln {(E/P)}_t=& \underset{(4.6)}{3.06}+\underset{(2.8)}{0.43}\ln {(M/P)}_{t-1}\\ & -\underset{(0.8)}{0.18}\ln Y_t\end{array}\\ \begin{array}{cc}\begin{array}{c}{R}^2=0.98\end{array}& DW=1.95\end{array}\end{array}$
Volume of imports	$\begin{array}{c}\begin{array}{cc}\ln {(IM/P^t)}_t=& \underset{\left(4.1\right)}{4.26}+\underset{\left(7.6\right)}{0.63}\ln {(GE/P)}_t\\ & +\underset{(4.7)}{0.89}\ln {(E/P)}_t\\ & -\underset{(1.1)}{0.83}\ln {(P^t/P^n)}_{t-1}\end{array}\\ \begin{array}{cc}\begin{array}{c}{R}^2=0.99\end{array}& DW=1.48\end{array}\end{array}$
Income identity	Y = (E + GE + PEX - IM)/P
Money supply identity	ΔM = GE - GDR + PEX - IM + C
Budget identity	GR = DR + OR.

¹Corrected for autocorrelation.

The estimation of the real private expenditures indicates that the excess supply of money was the main factor explaining the variations in the ratio of private expenditures to income. The adjustment coefficient was about 0.4, which indicates that somewhat less than half of any excess supply of money was reflected in the increase in private expenditures. The income elasticity of real private expenditure, e, is about 0.7.¹⁵

The estimation of the import equation indicates that the increase in government and private expenditures contributed significantly to the increase in imports. The elasticity of imports with respect to private expenditures is close to unity, which is higher than the elasticity with respect to government expenditures. The relative price coefficient has the correct sign but is not significant.

VI. Dynamic Simulations

In order to test the reliability of the model for predicting the movements of the endogenous variables, a dynamic simulation of the model was conducted over the period 1960-77, using the parameter estimates obtained in the previous section and the actual values of the exogenous variables. A comparison of the simulated values of the endogenous variables with their actual values provides a rigid test for the reliability of the model, because under this simulation procedure the lagged endogenous variables are generated by the model and the errors are accumulated over time.¹⁶ The results (Charts 1-9) indicate that the model tracks the actual movements of the endogenous variables over the period remarkably well and, consequently, it can be utilized to predict the behavior of key economic variables, even outside the sample period.

In order to quantify the impact of the oil price increases in 1973-74 on the economy, a second set of dynamic simulations was conducted when oil revenues were assumed to have increased at a constant rate during the 1973-77 period. This constant rate was set according to two alternative scenarios: first, the rate was set equal to the average rate of increase over the 1973-77 period (that is, 42 percent); and second, the rate was set equal to the average rate of increase over the 1960-72 period (that is, 17 percent). Under the first alternative, oil revenues increased more gradually and did not exhibit the abrupt increase observed in 1973-74; consequently, they did not reach the actual values observed until 1977. Under the second alternative, oil revenues fell well below the actual values observed. The simulation results for these alternative scenarios, designated by SIM 1 and SIM 2 (Charts 1-9), and their comparison with the previous dynamic simulation based on actual oil revenues, enable us to isolate the impact of the oil price increases on the economy. It should be noted that in our framework higher accumulation of international reserves is equivalent to lower oil revenues. Consequently, different simulations could be interpreted to represent different rates of reserve accumulations with similar increases in oil revenues.

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Broad Money

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Government Expenditure

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Government Total Revenue

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Government Non-Oil Revenue

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Consumer Price Index

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Home Goods Price Index

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The simulation results SIM 1 and SIM 2 indicate that the increase in oil revenues had a pronounced effect on the economy. Under the SIM 1 scenario a more gradual increase in oil revenues would result in a slower growth of government expenditure and, consequently, of output; the average growth of output would be about 11 percent, compared with the observed rate of 13 percent (Table 3). The lower growth of output would be accompanied by a lower inflation rate; the average inflation in home goods prices would be 8.6 percent, compared with the observed rate of 12.2 percent. The slower growth of output would also result in a slower growth of non-oil revenues, private expenditures, and imports.

Table 3.

Simulation Results: 1973-77

(In percent)

¹Oil revenues assumed to increase at an average annual rate of 41 percent.

²Oil revenues assumed to increase at an average annual rate of 17 percent.

Table 3.

Simulation Results: 1973-77

(In percent)

Average Growth of	Actual	Simulated	SIM 11	SIM 22
Government expenditure	38.0	36.9	33.1	16.0
Output	13.4	13.2	11.0	3.3
Price of home goods	12.2	11.2	8.6	8.6
Imports	34.4	36.5	30.9	15.2

¹Oil revenues assumed to increase at an average annual rate of 41 percent.

²Oil revenues assumed to increase at an average annual rate of 17 percent.

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Table 3.

Simulation Results: 1973-77

(In percent)

Average Growth of	Actual	Simulated	SIM 11	SIM 22
Government expenditure	38.0	36.9	33.1	16.0
Output	13.4	13.2	11.0	3.3
Price of home goods	12.2	11.2	8.6	8.6
Imports	34.4	36.5	30.9	15.2

¹Oil revenues assumed to increase at an average annual rate of 41 percent.

²Oil revenues assumed to increase at an average annual rate of 17 percent.

The importance of oil revenues to the economy becomes abundantly clear under the SIM 2 scenario. A reduction of the increase in oil revenues to the levels observed prior to 1973 would have resulted in a sharp decline in the growth of output to about 3 percent. On the other hand, the inflation in home goods prices would continue to remain at 8.6 percent, the rate observed under the SIM 1 scenario.

A comparison of SIM 1 and SIM 2 results reveals that an increase in oil revenues initially results in higher growth rates without inducing higher rates of inflation; the growth rate under SIM 1 is much higher than under SIM 2, while the inflation rate is the same in both cases. The initial stability in the inflation rate is due to the fact that the increase in income levels leads to an increase in the demand for money, matching the increase in money supply associated with higher government expenditures. After a point, however, limitations on the absorptive capacity of the economy set in, slowing down the growth of output and leading to an excess supply of money and to higher domestic inflation. Consequently, the benefits of additional growth from further increases in government expenditures beyond this point should be weighed against the costs of inflation.¹⁷

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Private Expenditure

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Real Output

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Imports

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VII. Conclusions and Policy Implications

In this paper we have developed a macroeconomic framework to evaluate the impact of the rapid increase in Iran’s oil revenues on its domestic economy. Our results confirm that higher oil revenues since 1973 were instrumental in improving the growth of the economy. Because of limitations on excess capacity in the economy, the higher growth rates were accompanied by higher rates of inflation in the prices of nontraded goods. Given a fixed exchange rate, the increase in the prices of non-traded goods led to a reallocation of resources from the traded goods sector to the nontraded goods sector; by 1977, non-oil exports had all but vanished, imports as a proportion of income had grown substantially, and the import-substituting sector was limited to those industries that were afforded substantial protection.

The above developments are a logical result of an oil producing country acting on its comparative advantage in oil. However, this policy ignores the fundamental difference between production based on the exploitation of exhaustible resources and the production of other goods and services. Oil resources represent a stock of capital assets in the economy, and if the capital stock is not to be depleted, oil revenues should be invested—either domestically or abroad—to provide a flow of earnings over time. Whether capital should be consumed at all is obviously an intergenerational choice, but it can be argued that in a less developed economy capital should not be depleted and, in fact, part of the earnings should be invested toward further diversification.

The basic policy implication of this analysis is that, in the longer run, oil producing countries need to develop non-oil industries and promote their traded goods sector if they are to sustain economic growth when the oil resources are exhausted. Financial policies should therefore be geared to the achievement of this longer-term objective. An important element of these policies would be to limit government domestic expenditures to levels consistent with the absorptive capacity of the economy.¹⁸ Otherwise, the rapid deterioration of relative prices against the traded goods sector would inhibit its development.