This Selected Issues paper analyzes economic growth in Iran. It uses a growth-accounting exercise to quantify the historical sources of growth over 1960–2002, including human capital accumulation and the contribution of Total Factor Productivity to growth. The paper presents an empirical study to quantify the role of several other contributing factors commonly discussed in the cross-country growth literature, including macroeconomic stability, financial development, trade openness, and the change in the terms of trade. The paper also examines issues in medium-term management of oil wealth in Iran.

Abstract

This Selected Issues paper analyzes economic growth in Iran. It uses a growth-accounting exercise to quantify the historical sources of growth over 1960–2002, including human capital accumulation and the contribution of Total Factor Productivity to growth. The paper presents an empirical study to quantify the role of several other contributing factors commonly discussed in the cross-country growth literature, including macroeconomic stability, financial development, trade openness, and the change in the terms of trade. The paper also examines issues in medium-term management of oil wealth in Iran.

CHAPTER II: Issues in Medium-Term Management of Oil Wealth10

I. Introduction

26. Under the third five-year development plan (2000/01–2004/05), Iran introduced a number of important fiscal reforms aiming at reducing the dependency of public finances on oil revenue and containing expenditure growth. These included a tax reform to strengthen the non-hydrocarbon revenue base, the establishment of an Oil Stabilization Fund (OSF, Appendix I) to cushion the impact of fluctuations in oil prices on expenditure, and actions to improve expenditure management and transparency.

27. Despite these efforts, fiscal reform in general has been partial and measures were often implemented in a piecemeal fashion under pressing domestic and external political circumstances. Moreover, periods of increases in oil prices provided temporary respites from underlying long-run fiscal problems and gave policymakers more leeway to increase expenditure. As a result, Iran’s public finances continue to face a number of key challenges: heavy dependence on hydrocarbon revenue, low non-hydrocarbon revenue, pro-cyclical fiscal policy, and excessive subsidization (Appendix II). The authorities need to address these issues in a medium-term framework, which should also help smooth the macroeconomic impact of fluctuations in oil prices, reduce inflation, and preserve hydrocarbon wealth for future generations.

28. This chapter outlines long-term objectives of preserving hydrocarbon wealth for future generations and discusses whether the current medium-term fiscal outlook developed by the staff is consistent with these objectives, as well as with the need to bring down inflation and reduce vulnerability to a decline in oil prices in the medium term. The discussion is focused on the central government operations, which are consolidated with the OSF, mainly because data limitations preclude the analysis of general government operations, including municipal budgets and the Social Security Organization.11 This chapter does not address the issues of quasi-fiscal activities, largely present in the banking system (Chapter III), or fiscal dominance over monetary policy (Chapter IV), or the relationship between public enterprises and the central government financial operations.

29. This chapter is organized as follows. Section II derives three sets of long-term simulations of consumption out of hydrocarbon wealth. Section III compares the results of these simulations with the staff’s baseline medium-term fiscal scenario and discusses whether a transition from the projected baseline scenario toward a fiscal position suggested by the simulations is feasible. Section IV concludes and recommends incorporating long-term considerations in the design of the medium-term fiscal framework with an emphasis on maintaining real per capita hydrocarbon wealth constant in the medium term.

II. Long-Run Considerations

A. Analytical Framework for Long-run Analysis

30. In oil-producing economies, fiscal policy should aim at accumulating substantial net assets during the period of oil production to sustain the non-oil deficits in the post-oil period (Barnett and Ossowski, 2003). This section draws on an intertemporal optimization framework 12 to estimate optimal government consumption and savings out of hydrocarbon wealth.13 In this context, intergenerational equity considerations are given prominence, while fiscal sustainability issues are not explicitly examined, assuming that the government intertemporal budget constraint is always met.14 The theory stipulates that the optimal consumption path is a function of the net present value of oil revenue, the initial net debt of the government, the real rate of return on assets, an intertemporal discount factor, the rate of population growth, and the degree of risk aversion (Box 2.1.).

Optimal Consumption out of Hydrocarbon Wealth

The purpose of this model is to determine an optimal rule on how to distribute hydrocarbon wealth across generations. The optimal solution to the government’s consumption level (1) which ensures intergenerational equity is defined as follows (Engel and Valdes, 2000):

U=1/(1ρ)βtCG,t1ρ(1)

where:

U is welfare function

β is a discount factor of the social planner in the welfare function; β =1/(1-γ) where γ is a discount rate

CG,t is government consumption at time t,

1/ρ denotes the coefficient of inter-temporal substitution of consumption between two periods, or the coefficient of relative risk aversion in a stochastic framework, and

n is the population growth rate.

Equation (2) defines the net wealth WG,0 as the starting net wealth FG,0 and the present discounted value of future oil revenues YG,s:

WG,0=FG,0+(1+r)sYG,s(2)

where:

r is a real rate of return on assets

YG,s is oil revenue in period s

Equations (3) and (4) define the optimal path of government current spending out of hydrocarbon wealth:

CG,0=(1α)(1+r)WG,0(3)
CG,t+1=[β(1+r)]1/ρCG,t(4)α=(1+n)[β(1+r)]1/ρ/r

where:

β(1+r)=1. Since the discount rate is equal to the real rate of return, the right hand side of (3) is simplified as:

CG,O=(rn)WG,O(5)

β(1+r)>1. If the welfare of future generations is discounted at 1 percent (implying β=0.99), consumption and GDP grow at CG,t+1/CG,t=[β(1+r)]1/ρ. It is straightforward that about 3-percent growth consumption is consistent with ρ=1.5 if β=0.99 and R=0.04.

If β(1+r)<1, there will be a decline in consumption growth no matter what ρ might be.

31. The paper presents three sets of simulations of a path for consumption out of hydrocarbon wealth. The first simulation assumes that the discount rate in the welfare function is below the real rate of return. This is consistent with positive long-term growth of per capita output and consumption and implies that the society is patient and saves enough to ensure real per capita growth in consumption out of hydrocarbon wealth. The second simulation assumes that the discount rate is equal to the real rate of return. Under this assumption, there is no long-term real per capita growth and, therefore, real per capita consumption out of hydrocarbon wealth will remain constant indefinitely, which is akin to the conclusions of the permanent income hypothesis. In the third simulation, a preservation of real hydrocarbon wealth is targeted. This is equivalent to assuming that the discount rate is higher than the real rate of return, given the positive rate of population growth.

32. The issue of whether savings are invested in financial or real (physical) assets does not affect the general conclusions of the optimal consumption theory. Public investment in infrastructure and human capital financed by savings from oil revenue can contribute to an increase in the long-run growth rate of the non-oil sector. Fiscal sustainability, however, requires that public investment be sufficiently productive to generate tax revenue higher than or equal to the prevailing return on financial assets of the equivalent amount.15 Assuming that this rule is observed, the following analysis does not make a distinction between investment in financial and physical assets.

33. As a share of oil revenue is saved and invested, the return on these investments becomes an important source of additional non-oil revenue for the budget. Accordingly, the government’s consumption out of hydrocarbon wealth can be measured by the non-oil current deficit, including implicit energy subsidies as current expenditure (Table 2.1), minus net interest income.16

Table 2.1

Islamic Republic of Iran: Estimates of Implicit Energy Subsidies, 2003/04

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Sources: World Bank; and Fund staff estimates.

34. Estimates of the path of optimal consumption out of hydrocarbon wealth are subject to significant uncertainties. They are highly sensitive to several factors, including long-run oil and gas prices, the volume of proven reserves, the extraction rate, and the real rate of return. Among the above assumptions, oil and gas prices are the most difficult to predict. In particular, some empirical research suggests that oil prices do not revert to a long-term mean, while others find only a very slow reversion and high persistence of shocks.17 Uncertainties regarding the oil revenue outlook may also stem from further discoveries of oil and gas reserves or the development of alternative energy sources. Thus, the estimated consumption path needs to be frequently revisited as new information may lead to large variations in estimates.

B. Implications for Iran of Long-Run Analysis

35. The estimate of hydrocarbon wealth hinges on a number of key assumptions. The assumed oil price of $22 per barrel is equal to a 10-year average oil price for the Iranian crude (1993–2003) in 2003/04 U.S. dollars. Given market segmentation for natural gas, measuring border prices for Iranian gas represents a major challenge. A conservative assumption of $41 per 1,000 cubic meters was retained in this scenario, which is somewhat lower than the 10-year average prices in Europe or North America. Based on proven reserves, the country’s oil and gas resources are estimated to last for 75 and 78 years, respectively, assuming that the extraction of oil grows at 1 percent per year and extraction of gas accelerates in the next decade and levels off subsequently. A real rate of return of 4.0 percent broadly in line with long-term real U.S. Treasury bond rates of 2 percent (60 percent weight) and real stock returns of 7 percent (40 percent weight) 18 is assumed. Government domestic and external debt, net of OSF foreign exchange deposits, is estimated at about $10 billion. Given the assumptions in Table 2.2, the overall oil and gas wealth, net of government debt, represents about $861 billion in 2003/04 dollars (Table 2.3).

Table 2.2.

Islamic Republic of Iran: Parameters of Estimates

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Sources: World Bank; BP Statistical Bulletin; and Fund staff estimates and projections.
Table 2.3.

Islamic Republic of Iran: Consumption out of Oil Wealth, 2003/04

(At current billions of U.S. dollars, unless otherwise undicated)

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Sources: Fund staff estimates and projections.

36. Simulation of optimal consumption out of oil wealth. According to equation (4) in Box 2.1., the optimal consumption out of hydrocarbon wealth is estimated at US$8 billion in 2003/04, versus the actual realization of about US$29 billion. Under this framework, the optimal per capita consumption out of hydrocarbon wealth should increase every year, which would help maintain the amount of consumption out of hydrocarbon wealth roughly constant in terms of GDP at about 5 percent indefinitely (assuming 3 percent real GDP growth in the long run, Figure 2.1).

Figure 2.1.
Figure 2.1.

Islamic Republic of Iran: Optimal Path for Consumption out of Oil Wealth

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A002

Source: Fund staff estimates.

37. Simulation of consumption out of oil wealth consistent with maintaining constant real per capita wealth. To maintain hydrocarbon wealth constant in real per capita terms, the consumption out of hydrocarbon wealth is estimated at US$25 billion in 2003/04. Under this framework, such consumption out of hydrocarbon wealth will increase in constant dollar terms every year at the rate of population growth, but will decline rapidly as a share of GDP because the rate of population growth of 1 percent is well below the assumed long-run GDP growth rate of 3 percent (Figure 2.2). Thus, to maintain the intertemporal budget constraint in the long run, the current primary deficits would need to decline in the future, which would require some additional fiscal measures.

Figure 2.2.
Figure 2.2.

Islamic Republic of Iran: Constant per Capita Real Consumption out of Oil Wealth

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A002

Source: Fund staff estimates.

38. Simulation of consumption out of oil wealth consistent with maintaining constant real wealth. To maintain hydrocarbon wealth constant in real terms, the real return (US$34 billion) on the entire wealth could be consumed from 2003/04 onward. The long-run implication of this assumption is that consumption out of hydrocarbon wealth in both real per capita terms and relative to GDP would decline steeply, potentially warranting sharp increases in taxation or reductions in expenditure to maintain the intertemporal budget constraint. Another concern associated with this scenario, which is not captured by the above framework, is a possible substantial real effective exchange rate appreciation that could result from the large spending out of foreign currency-denominated oil revenue. If sustained, such an appreciation could possibly cause a Dutch disease that would hinder the development of the non-oil sector.

39. Sensitivity to oil price assumptions. Only under the simulation of the optimal policy scenario, consumption out of hydrocarbon wealth can be maintained constant relative to GDP indefinitely. The corresponding current primary non-oil deficit estimated at about 5 percent of GDP is sensitive to assumptions on oil prices. Should the assumed real oil prices be higher (lower) during the projection period, then the long-run optimal consumption out of hydrocarbon wealth would increase (decrease) by about ¼ percent of GDP per each dollar in excess (or below) the baseline oil price of $22 per barrel. For instance, if the assumed real oil price is $30 per barrel, the optimal level of consumption out of hydrocarbon wealth is 6.8 percent of GDP, or about 2 percent of GDP above the level of consumption consistent with the baseline price of $22 per barrel. The government could maintain indefinitely consumption out of hydrocarbon wealth at its 2003/04 level relative to GDP (22 percent), only if the assumed real oil price were about $88 per barrel. Regarding the preservation of real per capita wealth scenario, consumption out of oil wealth is estimated to increase (decrease) by $1 billion in 2003/04 for each dollar in excess (or below) the baseline price. With respect to maintaining total real oil wealth, consumption out of oil wealth is estimated to increase (decrease) by almost $2 billion in 2003/04 for each dollar in excess (or below) the baseline price.

III. Consistency of the Baseline Medium-Term Framework with Long-Term Parameters

40. A stylized baseline medium-term fiscal scenario (Table 2.4) is developed as a reference for comparison with the three simulations presented above. This scenario is based on a number of assumptions on reforms contained in the draft fourth five-year development plan, including in the fiscal area. This scenario is also based on a conservative assumption of a steady decline in oil prices to about $24 per barrel at the end of the plan period, as well as a gradual fiscal adjustment, which will be achieved mainly through additional revenue measures, including the energy subsidy reform 19 and VAT implementation in 2006/07. A gradual reduction in explicit subsidies is also assumed. Finally, some “forced” expenditure restraint in the areas of capital spending and net lending is projected owing to financing constraints that Iran is likely to face in response to the projected decline in oil prices, as foreign or domestic borrowing may entail relatively high costs. In spite of the “forced” fiscal adjustment, the OSF deposits are likely to be depleted by the end of the projection period.

Table 2.4.

Islamic Republic of Iran: Baseline Medium-Term Scenario Under Current Policies, 2000/01–2009/10 1/

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Sources: Data provided by the Iranian authorities; and Fund staff estimates.

Iranian fiscal year ending March 20.

Using the current account balance from the balance of payments and the market-determined exchange rate.

41. All three sets of long-term simulations point to the need for a change in the fiscal stance under the baseline scenario (Figure 2.3).20 The baseline scenario is somewhat tighter than is needed to preserve hydrocarbon wealth in real terms over the next five years. Maintaining real per capita hydrocarbon wealth constant calls for additional moderate fiscal tightening relative to the baseline scenario (Figure 3.2). Shifting the fiscal stance toward the optimal consumption path will necessitate a drastic fiscal tightening relative to the baseline scenario, which is clearly not feasible over the medium term.

Figure 2.3.
Figure 2.3.

Islamic Republic of Iran: Scenarios for Consumption out of Oil Wealth, 2003/04–2009/10

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A002

Source: Fund staff estimates and projections.

42. While a transition toward an optimal consumption path would result in maintaining consumption out of hydrocarbon wealth constant relative to GDP indefinitely, 21 it can only be done in stages over the long run. As a first step, targeting the preservation of real per capita hydrocarbon wealth could be achieved over the medium term, and subsequently, considerations could be given to moving closer to maintaining constant consumption out of oil wealth relative to GDP.

43. To maintain oil wealth constant in real per capita terms, consumption out of oil wealth under the baseline scenario would need to be reduced by about 4 percentage points of GDP during 2004/05–2005/06 with a smaller adjustment of about half of one percentage point of GDP during 2007/08–2009/10. Given the need to reduce external and fiscal vulnerability to a potential decline in oil prices, an upfront fiscal adjustment is preferable as it is less costly to implement from a position of strength when oil prices are high. Indeed, the current fiscal impulse 22 has contributed to a significant decline in the current account surplus despite higher oil prices, making the external position more vulnerable to a possible decline in oil prices in the medium term. However, a fiscal tightening of about 4 percentage points of GDP per year at the beginning of the projection period, relative to the baseline scenario, appears excessive, as it could have an unacceptably high output cost.

44. Short-term constraints on fiscal policy in oil-producing countries mainly arise because the injection of large amounts of oil revenue has important implications for domestic demand and liquidity growth. In Iran, the fiscal relaxation of 1999/2000–2003/04 has led to difficulties in achieving monetary policy objectives. In the face of massive injections of oil revenue, the central bank was unable to fully sterilize the related liquidity effect either through sales of foreign exchange or issuance of participation papers. The former were not fully used due to concern over negative effects of a possible nominal currency appreciation on the non-oil economy, while the latter rapidly reached its limits, given the high cost to the central bank (Chapter IV). As a result, the exchange rate continued to depreciate in nominal terms, monetary aggregates grew faster than targeted, and inflation increased during 2002/03–2003/04. An upfront fiscal tightening relative to the baseline scenario would help meet the authorities’ monetary policy objective to bring down money growth and reduce inflation.

IV. Conclusion

45. The paper relies on a long-term analytical framework to determine criteria for preserving hydrocarbon wealth for future generations. In this context, it presents three possible long-run criteria in comparison with the staff’s medium-term baseline fiscal scenario. These criteria comprise: maintaining total real hydrocarbon wealth constant; preserving real per capita hydrocarbon wealth; and targeting optimal consumption out of hydrocarbon wealth. The baseline fiscal scenario is broadly in line with maintaining total real hydrocarbon wealth constant. Conversely, additional fiscal adjustment relative to the baseline is needed to move toward preserving real per capita hydrocarbon wealth or converging with the optimal path for consumption out of hydrocarbon wealth. Short- and medium-term factors are likely to play a crucial role in choosing the appropriate medium-term path of fiscal adjustment. Given the current fiscal stance, it is likely that a feasible option would be close to the preservation of hydrocarbon wealth in real per capita terms rather than to the optimal path. This means that additional fiscal measures might need to be considered beyond the medium term to deal with the projected decline in consumption out of hydrocarbon wealth relative to GDP.

REFERENCES

  • Davis, J.M, R. Ossowski, and A. Fedelino, 2003, Fiscal Policy Formulation and Implementation in Oil-Producing Countries (Washington: International Monetary Fund).

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  • Davis, Jeffrey, Rolando Ossowski, and Steven Barnett, 2001, Stabilization and Savings Funds for Nonrenewable Resources: Experience and Fiscal Policy Implications, IMF Occasional Paper 205 (Washington: International Monetary Fund).

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  • Davoodi, Hamid, 2002, “Assessing Fiscal Vulnerability, Fiscal Sustainability, and Fiscal Stance in a Natural Resource Rich-Country,” in Republic of Kazakhstan—Selected Issues and Statistical Appendix, IMF Staff Country Report No.02/64, (Washington: International Monetary Fund).

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  • Engel, Eduardo, and Rodrigo Valdes, 2000, “Optimal Fiscal Strategy for Oil Exporting Countries,IMF Working Paper 00/118 (Washington: International Monetary Fund).

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  • Wakeman-Linn, John, Chonira Aturupane, Stephan Danninger, Koba Gvenetadze, Niko Hobdari, and Eric Le Brogne, 2004, Managing Oil Wealth: The Case of Azerbaijan, (Washington: International Monetary Fund).

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APPENDIX I The Oil Stabilization Fund

46. The Oil Stabilization Fund was established in December 2000 with the objective of insulating the budget from fluctuations in oil prices. The Fund was established as a foreign currency account at the central bank and is managed by an Executive Committee comprised of the Minister of Economy and Finance, the head of the Management and Planning Organization, the Governor of the central bank, and two members of Parliament.

47. The TFYDP established a U.S. dollar ceiling on the oil export revenue that can be transferred to the budget, based on an oil price of about US$16 per barrel. Additional transfers must be approved by Parliament (Appendix I Table 1). Oil revenues in excess of the budgeted amount are transferred to the OSF. If the realized crude oil export revenue is less than the annual budget allocation by the end of the eleventh month of fiscal year, the central bank draws from the OSF the amount required to compensate for the shortfall and transfers its equivalent in rials to the Treasury.

Table 1.

Islamic Republic of Iran: Oil Stabilization Fund, 2000/01–2003/04

(In millions of U.S. dollars)

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Source: Central Bank of Iran.

48. All OSF foreign assets are held in a foreign currency deposit account at the Central Bank and at most 50 percent may be lent out domestically in foreign currency through the domestic banking system to the private sector at rates of return close to LIBOR. A firm may borrow from the OSF over an eight-year period and is required to reimburse its loan from the fifth to the eighth year of the project. The required collateral for the loan may be land, machinery, equipment and corporate bonds.

APPENDIX II Subsidies in Iran

49. Explicit subsidies include budgetary subsidies to households for a number of essential commodities such as wheat, rice, oil, sugar, milk, and cheese; imports of medical equipment and pharmaceuticals; fertilizers; as well as for some debt service payments on publicly-guaranteed debt. Initially, most of these subsidies had been provided implicitly through the subsidized exchange rate until the 2002 exchange rate unification when they became explicitly reflected in the budget. Subsidies are also provided to farmers by a specialized government-owned agency to guarantee minimum purchase prices of agricultural products. Food subsidies are rationed through coupons, which are given to all households irrespective of their income levels. In recent years, the government has gradually reduced explicit subsidies to food, although they still constituted about 4 percent of GDP in 2003/04. Subsidies to cover exchange rate losses on debt service are declining rapidly, as debt contracted prior to the 1993 and 2002 unifications comes to maturity.

50. Implicit energy subsidies have given rise to misallocation of resources, waste and over consumption of energy products. As a result, Iran has become one of the most energy-intensive countries in the world. Total oil consumption amounted to 1.5 million barrels per day in 2002/03, similar to Spain’s, with a GDP six times higher than Iran’s. Also, air pollution is emerging as one of the main environmental and health problems especially in Tehran.

10

Prepared by J. Bailen and V. Kramarenko

11

According to a preliminary World Bank study, the Social Security Organization is not expected to face any cash flow problems owing to positive demographic dynamics for the next 10 to 15 years. However, beyond this period, deficits are expected to emerge, but the exact amount of unfunded liabilities is not available.

12

Engel and Valdes (2000) provide an overview of the application of optimal consumption models to the analysis of fiscal sustainability in oil-producing countries.

13

See also Azerbaijan (Wakeman-Linn, et al., 2004) and Kazakhstan (Davoodi, 2002).

14

The intertemporal budget constraint requires that hydrocarbon wealth be equal to the present value of future current primary balances. All simulations in this paper assume that any estimated decline in consumption out of oil wealth relative to GDP will be matched either by revenue or expenditure measures to maintain the intertemporal budget constraint. The issue of medium-term fiscal sustainability is not addressed in this paper as it is a more complex concept involving the analysis of the composition of government net debt by maturity, currency and instruments, as well as financing constraints.

15

This principle is valid regardless of the presence of oil resources.

16

In the rest of this chapter, the non-oil primary current deficit refers to this definition.

17

Cashin, Liang, and McDermott (1999) and Engel and Valdes (2000).

18

These weights are chosen for illustrative purposes only. The optimal weights should be determined based on a Capital Asset Pricing Model.

19

Based on broad indications regarding the planned energy price reforms, it is assumed that energy prices will be increased by 25 percent per year with two-thirds of the additional revenue generated by the reform spent on social protection and public investment.

20

Since the fiscal position in 2003/04 was not consistent with any of the three simulations, moving towards the indicated position in each simulation in 2004/05 will not strictly speaking result in the achievement of the desired long-run objectives. While moderate deviations for one or two years from the simulated paths are not expected to significantly alter hydrocarbon wealth dynamics, large deviations for longer periods could undermine the achievement of initial long-run objectives.

21

Barnett and Ossowski (2003) recommend this criterion as a benchmark of long-run fiscal sustainability in oil-producing countries.

22

The non-oil fiscal deficit increased from 10.8 percent in 1999/2000 to 18.7 percent of GDP in 2002/03, and it subsequently declined to 16.4 percent in 2003/04.

Islamic Republic of Iran: Selected Issues Paper
Author: International Monetary Fund
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    Islamic Republic of Iran: Optimal Path for Consumption out of Oil Wealth

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    Islamic Republic of Iran: Constant per Capita Real Consumption out of Oil Wealth

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    Islamic Republic of Iran: Scenarios for Consumption out of Oil Wealth, 2003/04–2009/10

    (In percent of GDP)