Abstract
This Selected Issues paper on Iran focuses on the Targeted Subsidy Reform Law (TSRL). This is the basic law governing the implementation of the subsidy reform in Iran. The TSRL envisaged bringing subsidized prices close to international levels over a five-year period. The paper reviews the implementation of the first phase of the subsidy reform, with a particular emphasis on macroeconomic management. The sharp depreciation of the exchange rate and high inflation significantly undermined progress under the reform. High inflation partially reversed the relative price change under the reform.
Monetary Policy and the Inflation-Output Tradeoff in Iran1
1. Iran’s macroeconomic performance over the past twenty years has displayed higher inflation than output volatility in a cross-country comparison. Three stylized facts stand out about Iran’s inflation and output performance over the last two decades. First, the level and variability of inflation in Iran have been persistently above the median of a sample of other oil-exporting countries. Second, Iran’s record of containing the variability of non-oil output is more favorable, being below the median. Third, both inflation and output variability have risen markedly since the mid-2000s. Part of the increase was due to the global financial crisis. But in explaining the three facts together, the role of macroeconomic stabilization policies, particularly monetary policy, emerges as a crucial factor. Monetary policy can stabilize either prices or output in the face of supply shocks, but not both—inflation and output stabilization are policy tradeoffs when dealing with supply shocks. Examining actual outcomes of inflation and output after well-identified supply shocks therefore helps shed light on the authorities’ relative preferences in stabilizing the economy.
2. A simple macroeconomic model infers the authorities’ preferences for stabilizing inflation and output in two sub-periods. In the first step, the model estimates the relative preferences over inflation and output stabilization (alternatively, the degree of inflation aversion) for the period 1991–2010. The preferences that the authorities “revealed” over this time period yields a reference point, which serves as benchmark to assess the policy response to the two large shocks that have hit the Iranian economy in the years 2011–12: (i) the subsidy reform, and (ii) the tightening of international economic sanctions. Predictions from a simple policy reaction function give additional context for characterizing the policy response.
3. The policy response to the negative shocks in 2011–12 is consistent with a higher tolerance for inflation, indicating a need to rethink the monetary policy framework. Recognizing the large magnitude of the shocks, parameter estimates of the macroeconomic model suggest that inflation variability increased proportionally more than output variability. This result suggests that the policy response aimed towards stabilizing output, possibly due to constraints on the CBI’s ability to contain inflation. A simple policy reaction function in the spirit of Taylor (1993) also points to a greater emphasis on output stabilization in this period. Several factors can explain why the policy response did not control inflation better, including institutional weaknesses in the conduct of monetary policy. By revisiting the experience of countries that permanently reduced inflation, the paper concludes with recommendations for strengthening the monetary policy framework in Iran.
Islamic Republic of Iran: The Inflation-Output Stabilization Tradeoff
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ The output gap is the cyclical component of HP-filtered real non-oil GDP series.Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: The Inflation-Output Stabilization Tradeoff
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ The output gap is the cyclical component of HP-filtered real non-oil GDP series.Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: The Inflation-Output Stabilization Tradeoff
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ The output gap is the cyclical component of HP-filtered real non-oil GDP series.Sources: Iranian authorities; and IMF staff calculations.A. A Brief Narrative of the Shocks and the Policy Response of 2011–12
4. The subsidy reform and the tightening of international economic sanctions imparted large, negative supply shocks to the economy. Although the shocks also affected demand through balance sheet and income channels, their main impact was to increase costs of production.1 The subsidy reform led to sharp increases in the price of several subsidized energy products (gasoline, fuel oil, kerosene, diesel, and electricity), directly raising input costs for businesses and households. Likewise, the new economic sanctions of 2012 barred the Iranian banking system from transacting in the international financial system, impairing Iran’s ability to import factors of production. In particular:
Subsidy reform (2011). The authorities initially brought down base money growth by selling foreign exchange and gold. However, this response faded later in 2011, as the injections of domestic liquidity from credit to specialized banks—largely associated with the funding to the Mehr Housing Program—and the government turned out too large to sterilize with foreign exchange interventions. The exchange rate started to depreciate in the parallel market around April 2011, at first gradually but more abruptly towards the end of the year. There was limited response from monetary policy, except by aiming to tighten credit to other sectors of the economy while accommodating social programs, like for housing.
International Sanctions (2012). In 2012, the United States and other countries introduced sanctions on Iranian oil exports and financial transactions, putting additional pressure on the foreign exchange market. The MCC raised the rates of return on bank deposits and central bank-issued participation papers in early 2012. Some private banks took an additional step and set interest rates above the official ceilings on some type of term deposits. Despite these increases, real interest rates descended into increasingly negative territory, and few banks were interested in buying the participation papers. One important consequence of the sanctions was that they impaired the CBI’s ability to transact in dollars. The CBI therefore did not intervene on a large scale in the foreign exchange market to sterilize the large liquidity injections throughout the year. Instead, the authorities introduced a two-tiered official exchange rate system, with the appreciated rate applying to imports of food and other basic goods. Yet, against the background of the large real depreciation in the parallel foreign exchange market, inflation accelerated sharply.
Islamic Republic of Iran: Indicators of the Monetary Policy Stance
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: Indicators of the Monetary Policy Stance
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: Indicators of the Monetary Policy Stance
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.5. A simple macroeconomic model shows that the goals of inflation and output stabilization carried about equal importance in 1991–2010. Appendix I lays out the technical details of the estimation. The model’s main results are:
The estimated degree of inflation aversion α equals 0.49, consistent with Iran’s relatively high inflation and relatively low output variability. An α of less than 0.5 is relatively low, indicating only a mild preference for inflation stabilization. In a study of advanced and emerging market economies, Cecchetti and Ehrman (2002) found alphas ranging from 0.99 to 0.50. Only Belgium and Mexico had lower values for α than Iran. This study covered earlier periods when Mexico had not yet adopted inflation targeting and Belgium still had its own currency. The finding in this study of a comparatively small number for Iran’s α reinforces the conclusion of the cross-country comparison in the introduction, that Iran was unable to contain inflation variability.
The inverse of the aggregate supply curve γ suggests that the output costs of disinflation could be small. The impulse response functions of a vector autoregression yield an estimate of γ=0.78, which is in the bottom quintile of the estimates in Cecchetti and Ehrman (2002). A low gamma implies a steep aggregate supply curve, which in turn means that output is not very sensitive to changes in prices. Differently, the inflation/output variability frontier is relatively flat, indicating that swings in inflation have to be large to help keep output closer to target. In standard macroeconomic theory, the slope of the aggregate supply curve depends on the degree on nominal rigidity in the economy, which in turn varies with the credibility of the monetary policy framework. If credibility is relatively low, companies try to avoid keeping the prices of their goods fixed for too long. They are in the habit of adjusting prices rapidly when inflation changes, reducing nominal rigidity. Companies with flexible prices are less likely to alter production plans when unexpected deviations in inflation materialize, and as a result, output is not very responsive to inflation (Mankiw and Reis, 2011).
6. Examining the policy response of 2011–12, the model suggests a shift in preferences towards stabilizing output over inflation. The subsidy reform and the intensification of sanctions enter equations (1) and (2) in Appendix I as negative realizations of st, forcing the Iranian authorities in their policy response to focus on inflation or output stabilization. To compare the authorities’ policy response to their long-run behavior, it is useful to think of the model’s solution (Appendix I) as a frontier of inflation and output variability. Each point on the frontier corresponds to a different degree of inflation aversion α, assuming that the economy operated with the same aggregate supply curve. The actual ratio of output and inflation variability over the two-year period of 2011–12 shows a shift toward a new point on the frontier, corresponding to α=0.32. Because of the relatively flat slope of the inflation/output variability frontier, the gain in lowering output variability came at the expense of a significant increase in inflation variability. Note that the estimated α for the years 2011–12 is likely an upper boundary. The authorities introduced several administered measures to contain inflation immediately after the subsidy reform. Without these controls, recorded inflation variability would have likely been higher.
Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ By plotting the performance points on the frontier, this chart assumes that the CBI acted optimally. Specifically, the CBI minimized inflation and output variance, subject to the constraints imposed by the structure of the economy. See Annex I.Sources: Iranian authorities; and IMF staff calculations.Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ By plotting the performance points on the frontier, this chart assumes that the CBI acted optimally. Specifically, the CBI minimized inflation and output variance, subject to the constraints imposed by the structure of the economy. See Annex I.Sources: Iranian authorities; and IMF staff calculations.Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
1/ By plotting the performance points on the frontier, this chart assumes that the CBI acted optimally. Specifically, the CBI minimized inflation and output variance, subject to the constraints imposed by the structure of the economy. See Annex I.Sources: Iranian authorities; and IMF staff calculations.7. Estimating a simple policy reaction function is another way of detecting a shift in preferences. The reaction function derives from a GMM-regression of base money growth on the output gap and the deviation of inflation from target over the period 1991–2010. The regression equation is similar to Clarida, Gali, and Gertler’s (2000) with two differences. First, base money replaces the interest rate as the dependent variable, the monetary policy indicator that the authorities control. For most of the sample period, the CBI targeted a growth rate in base money to implement its desired policy stance. And in episodes when trying to peg the exchange rate of the rial, the CBI controlled base money growth through foreign exchange interventions to ensure that the monetary policy stance was consistent with the chosen exchange rate target. Second, the nominal exchange rate acts as an indicator of inflation instead of inflation itself, given the high share of tradeables in the consumption basket.
8. Predictions from this policy reaction function corroborate the increased concern on stabilizing output over inflation. Using the estimated coefficients and the realizations of the output gap and the nominal exchange rate in the parallel market in 2011–12, the function predicts the rate of money growth that would have been consistent with the way the authorities’ conducted monetary policy in the period 1991–2010. The first result is that monetary policy in the immediate aftermath of the subsidy reform appears to have been relatively tight, with negative base money growth in the face of a widening output gap. However, the situation reversed in 2012, which is the second result. The central bank started to scale back sterilization operations that aimed to contain the impact on base money from earlier surges in central bank credit to the government and specialized banks. Monetary policy turned expansionary even though the exchange rate started to depreciate, sending inflation soaring.
Islamic Republic of Iran: The Conduct of Monetary Policy
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: The Conduct of Monetary Policy
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Islamic Republic of Iran: The Conduct of Monetary Policy
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.9. The benefits in terms of output stabilization from accepting higher inflation are diminishing. The significant increase in inflation variability since 2011 has not prevented a spike in output variability, suggesting that the benefits from accommodating inflation are small. This interpretation would also suggest that monetary policy could have played a greater role in containing inflation variability without imparting significant costs in terms of output. In fact, the estimated flatness of the inflation/output variability frontier, resulting from the steepness of the aggregate supply curve, indicates that output does not seem very responsive to the state of demand. Instead, output moves primarily as a function of supply side constraints. Demand shocks tend to mainly affect prices, and this the more so when inflation is at high levels. Therefore, to regain control over output movements at reasonable levels of inflation variability, the Iranian economy should move to the left of the inflation/output variability frontier. In terms of the Cecchetti’s (1998) model, moving leftwards on the frontier involves raising α, the policy preference for inflation stabilization. One crucial determinant of policy preferences for inflation stabilization is the institutional design of the monetary policy framework.
10. The policy response of 2011–12 reflects the intrinsic tensions that arise when large supply shocks hit the economy and the monetary authorities face competing goals. In particular:
The official mandate for monetary policy contains several goals that are often times competing. The Monetary and Banking Act of 1960 lays out the official mandate of the CBI in conducting monetary policy, specifically: (i) maintaining a stable exchange rate; (ii) keeping the balance of payments in equilibrium; (iii) facilitating trade; and (iv) raising economic growth. The legal mandate does not enunciate whether all four goals carry the same importance, and how to deal with possible conflicts between them. Price stability, the overriding monetary policy objective for most central banks, does not appear.
The institutional decision-making process limits the CBI’s operational independence. The government and the private sector figure prominently in the Money and Credit Council (MCC), the body responsible for deciding on the monetary policy stance. It counts 13 members, composed of three monetary policy experts (including the CBI Governor as chairman) and ten representatives from government and the private sector. Voting is by simple majority. Although the implementation of the monetary policy stance lies legally in the ambit of the CBI, the CBI does not possess full control over all the instruments in the monetary policy toolbox. The MCC, not the CBI, determines the level of interest rates that the CBI charges for its standing facilities and the rate of return on participatory notes, a liquidity-absorbing instrument. Similarly, specialized banks receive subsidized funding from the CBI to finance government-mandated social programs (particularly housing), which affects base money. Foreign exchange intervention is under the control of the CBI, but international sanctions have impaired the scope to use reserves for sterilization purposes. Reserve requirements and prudential measures are the remaining tools. But the effectiveness of these instruments is limited if the CBI cannot exert full control over base money and interest rates to back them up.
The multifaceted mandate complicates accountability. The General Assembly of the CBI is the official body responsible for scrutinizing and appraising the performance of the CBI in fulfilling its mandate. Ideally, the starting point of the appraisal should be a view as to whether the CBI met its official goals. However, if the CBI cannot attain all four official goals at the time, performance appraisals need to evaluate the trade-offs between the goals. Without legal guidance for establishing a goal hierarchy, the General Assembly faces the difficult task of judging performance without a suitable yardstick.
11. Iran’s most important de-facto nominal anchor, the exchange rate, has not always been an effective signaling device. Since the unification of the foreign exchange market in 2002, the exchange rate has been the CBI’s defacto nominal anchor that constraints the conduct of monetary policy. However, the exchange rate is not necessarily an optimal nominal anchor in an economy such as Iran. The multitude of official monetary policy objectives complicates the interpretation of exchange rate targets (Mishkin, 1999). In the period 2006–08, for example, the relatively stable exchange rate could signal different stances of monetary policy—a more neutral stance in meeting the legal mandate of keeping the exchange rate stable or a more expansionary stance in an attempt to boost short-term growth. Given that inflation rose rapidly during that period indicates that the policy stance was likely too expansionary. More generally, inappropriate monetary policy stances can continue for some time under exchange rate targets if capital is not perfectly mobile. In Iran, restrictions on capital outflows blunt the automatic feedback loop between monetary policy and the exchange rate because residents cannot freely balance their rials and foreign currency portfolios.
Inflation and the Exchange Rate
(In percent)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Inflation and the Exchange Rate
(In percent)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Inflation and the Exchange Rate
(In percent)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.12. In sum, there is scope to rethink Iran’s current monetary policy framework to strengthen its credibility and effectiveness. Changing the design of the monetary policy framework can give a greater priority to inflation stabilization. This step would allow Iran to take advantage of its flat inflation/output variability frontier, bringing down inflation without significant output costs. The following reform options stand out: (i) clarifying the mandate with a clear commitment to price stability; (ii) strengthening the operational independence of the CBI; (iii) enhancing accountability mechanisms; and (iv) improving the communication with the public about the monetary policy stance and inflation goals.
13. Examining the experience of emerging markets that successfully overcame periods of high inflation can provide valuable options to rethink the framework. The experiences of other historically high-inflation countries, such as Brazil, Indonesia, Kazakhstan, Mexico, Malaysia, Nigeria, Turkey, and Saudi Arabia (Appendix II), offer valuable lessons to stabilize inflation and output through institutional reform. Salient elements in their reform agenda include:
A public announcement of central bank operational independence typically marks the beginning of the reform. Independence tends to take effect immediately with the announcement, although the legislative process that enshrines central bank independence in law may take longer. The new central bank legislation typically prohibits central banks from financing government deficits and insulates the operations of central banks from political influence. However, the government remains responsible for setting official goals; the central bank is only independent in its operational pursuit of these goals. One crucial element in this regard is the dissociation of appointments of central bank management from the political election cycle. Additionally, the new legislation grants central banks the authority to deploy with greater degrees of freedom all available instruments in the pursuit of monetary policy goals.
To foster transparency and accountability, price stability usually turns into the primary, if not sole, objective of monetary policy. Making price stability the overriding objective of monetary policy is appealing because price stability is easily understood and consistent with notion that monetary policy cannot affect real variables such as output in the long run (Friedman, 1968). Output and employment can be explicit secondary goals, as in the case of Malaysia and Turkey. With clear and easily understood targets, governments and parliaments are better placed to hold monetary authorities accountable for macroeconomic outcomes. For example, in Brazil, Indonesia, Mexico, and Turkey, the governor of the central bank appears before parliament to explain and defend monetary policy choices. In the same vein, most central banks in the sample have started to publish economic reports for the public at regular frequencies that contain detailed assessments of the economy and forecasts of inflation, economic growth, and possible policy responses. The bodies deciding on the monetary policy stance, typically committees, also publish minutes of their meetings on a regular basis.
Short-term interest rates move to the center as the main policy instrument. Quantitative monetary targets lose in relevance in monetary policymaking, given that base money becomes endogenous when central banks set short-term interest rates. The instability of money demand has been an additional reason for deemphasizing quantitative targets. Changes in money demand make the relationship between money on the one hand and inflation and output on the other hard to predict.
14. The rest of the overall macroeconomic policy framework needs to be supportive of monetary policy reform. The most significant structural reform that accompanied and facilitated monetary policy reform was the commitment to overcome fiscal dominance. Fiscal dominance implies that the fiscal policy stance effectively determines the monetary policy stance as well (Sargent and Wallace, 1981). The channels through which fiscal policy affects monetary policy vary across countries, but often involve central bank financing of government deficits and the creation of liquidity due to repatriations of foreign exchange-denominated commodity revenue. To sever the link between the fiscal and monetary sectors, the government has to make a strong commitment to fiscal discipline. Essential measures in this context are modernizing public financial management systems, reforming tax codes, and limiting central bank financing of fiscal deficits.
15. The case of Turkey is particularly instructive in that it shows that institutional reforms can change the tradeoff between inflation and output. Turkey grappled with chronically high inflation for much of the 1990s. Following a sharp reversal of capital flows and an associated currency crisis in early 2001, the Turkish authorities overhauled their monetary policy framework (see Box 1), with great success. Estimating Cecchetti’s model (1998) model for Turkey during the pre-crisis period results in estimates of α=0.24 and γ = 0.96. Remarkably, in the post-crisis period, α rose to 0.71, close to a threefold increase. Likewise, γ jumped to 1.66, suggesting that the aggregate supply curve flattened and control over output movements improved. This case study shows how institutional reform can dramatically bolster the credibility of monetary policy and give the monetary authorities greater control over economic growth.
B. Concluding Remarks
16. A flat inflation/output variability frontier reduces the costs of disinflation. In principle, a flat frontier is a double-edged sword. At times of negative supply shocks, it makes it very costly to attempt to stabilize output. For a given reduction in relative output variability, inflation variability surges disproportionately more. The policy response in 2011-12 illustrates this point. Inflation variability surged, yet without preventing the significant downturn in output (and increase in output variability). This pattern is consistent with the results of Jalali-Naini and Naderian (2012) who find that monetary policy is not a reliable instrument to boost output in Iran, instead primarily affecting inflation expectations. However, the flat shape of the frontier turns into a significant advantage if the objective is to bring down inflation variability from high levels. The results in this paper suggest that inflation stabilization in Iran could succeed at negligible output costs. The reason is that the aggregate supply is steep, and changes in demand will predominantly affect prices as opposed to output.
17. Revamping the monetary policy framework will help to permanently reduce inflation variability. The shocks of 2011–12 exposed several constraints in the current monetary policy framework. Reforms to the monetary policy framework in other emerging economies that once suffered from chronically high inflation variability offer valuable lessons for Iran. By reorienting the CBI’s mandate on price stability, bolstering its independence, and enhancing the transparency and accountability of its operations, the authorities could reap large benefits in terms of controlling inflation variability while avoiding large swings in output.
The Turkish Experience in Reforming Its Monetary Policy Framework
Turkey suffered a decade of significant economic volatility in the 1990s. Average economic growth was 4 percent, involving swings from 9 percent (1990) to −5 percent (1994). Inflation averaged close to 80 percent per year. Following the liberalization of the capital account in 1989, surging capital inflows put upward pressure on the real exchange rate and worsened the current account. Under weak financial regulation, banks took on excessive interest rate and exchange rate risks by relying heavily on short-term external borrowing.
In November 2000, the failure of one domestic bank caused a widespread liquidity crunch. The following months saw a marked deterioration in the political climate, eventually leading to full-blown crisis of confidence in February 2001. Overnight interest rate shot up to around 5,000 percent (annualized) and the stock market lost 40 percent of its market capitalization. Emergency liquidity injection contributed to a sharp loss in foreign reserves. To stem the balance of payment crisis, the authorities decided to float the Turkish lira later in February. The currency depreciated more than 50 percent by the end of the year.
The economic ramifications of the crisis were large. Inflation approach pre-crisis heights and public debt rose to close to 100 percent of GDP as a consequence of bank recapitalizations. Real GDP declined 5 percent peak-to-through and unemployment rate climbed into double digits in the aftermath (up from 6 percent prior to the crisis).
The twin pillars of the post-crisis reform strategy were disinflation and restoring fiscal sustainability. Immediately after the crisis, the Central Bank of Turkey (CBT) gained full operational independence with amendment to the central bank law. The law established: (i) price stability as the CBT’s primary policy objective; (ii) accountability of the CBT’s senior management for maintaining price stability before the government and parliament; (iii) a monetary policy committee (MPC) responsible for monetary policy decision-making and providing information to the public on a regular basis; and (iv) a ban for the CBT of lending directly to the Treasury from November 2001.
In addition, the CBT adopted an implicit inflation targeting (IT) regime. As an interim step, CBT targeted base money while using inflation as an implicit nominal anchor in the period of 2002-05. The new regime clearly specified that in the case of inconsistencies between monetary and inflation targets, the CBT would have to revise the money targets. Under this framework, inflation fell from 29.7 percent in 2002 to 7.7 percent in 2005; at the same time, growth actually strengthened from 5 to 8 percent. A fully-fledged IT regime became operational in 2006.
Ending fiscal dominance was a critical element in the reform strategy, helping to break entrenched inflationary expectations. A new government came into office in 2002 on the platform of fiscal consolidation. Supported by financial assistance from the IMF, the government turned its attention to generating sustained primary surpluses by means of increasing tax revenue and cutting inefficient government spending. The Public Financial Management and Control Law of 2003 further strengthened the overall fiscal framework, improving budget execution, control, and medium-term planning.
Appendix I. Model to Illustrate the Tradeoff Between Inflation and Output Stabilization
1. The tradeoff between inflation and output stabilization arises because supply shocks move output and inflation is opposite directions. A simple, stylized macroeconomic model by Cecchetti (1998) helps to illustrate the tradeoff. The model posits that supply and demand shocks and monetary policy determine output and inflation. Concretely:
where yt is non-oil output, bmt base money (the monetary policy instrument), dt and st are demand and supply shocks, γ and ω are parameters that measure the relative responses of output and inflation to demand and supply shocks. γ also gauges the relative impact of policy shocks (changes in bmt on non-oil output and inflation, where the impact is normalized to one in equation (2). One economically meaningful interpretation of γ is to relate it to the inverse of the aggregate supply curve, with higher values indicating a flatter, or more elastic, aggregate supply curve. Equations (1)–(2) capture the notion that the authorities can use monetary policy to neutralize demand shocks. But faced with supply shocks, which have opposite effects on non-oil output and inflation, they have to decide which of the two to stabilize. Assuming that the authorities care about keeping both inflation and non-oil output close to their target, the following loss function represents their preferences:
The model implies that degree to which they offset supply shocks depends on α, the relative preference for inflation stabilization, and the parameters γ and ω. In equilibrium, the relative variability of output and inflation describe a frontier given by:
The intuition underpinning equation (4) is straightforward: a higher preference for inflation stabilization α will lead to higher non-oil output variability relative to inflation variability, and a higher sensitivity of non-oil output to monetary policy γ will lower output variability relative to inflation variability. Diagrammatically, changes in α involve a move along the frontier, whereas different values for γ tilt the frontier.
Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.Output/Inflation Variability Frontier
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A002
Sources: Iranian authorities; and IMF staff calculations.2. The ratios of non-oil output and inflation variability are observable, provided the targets of both variables are known. There are two ways of fixing the targets of inflation and non-oil output in equation (3), using: (i) the official targets embedded in the government’s successive five-year plans, or (ii) the trend component of the HP-filtered series of inflation and non-oil output. The model’s results are insensitive to the choice of targets because both options deliver very similar quantitative estimates.
3. The estimate of γ is equal to the ratio of the average impulse response of output to the average impulse response of prices to a shock to base money. The impulse response functions, in turn, derive from a three-variable vector autoregression (VAR) of base money, consumer prices, and non-oil output. The identification scheme of the structural monetary policy shocks follows a standard Cholesky decomposition, with the ordering base money, prices, and output (different orderings give identical results). To control for the effect of shocks in international oil markets on the supply side of the Iranian economy, an alternative specification includes the value of oil exports as an exogenous variable. The results of this alternative specification give a virtually identical estimate of γ.
4. With the observed ratio of non-oil output and inflation variability and an estimate of γ at hand, equation (4) gives an estimate of α=0.49. This estimate implies that the Iranian authorities assigned equal importance to stabilizing inflation and output around their targets. Note that an equal weight on minimizing output and inflation variability in equation (3) do not imply that the empirical ratio of these variabilities will be equal to one. The structure of the economy, captured by the aggregate supply parameter γ, matters as well. Remember that a higher γ means that output is relatively elastic, making inflation stabilization more costly. So for given variability ratios, a higher γ implies a higher α. Countries whose economic structure makes it costly to reduce inflation variability must have a higher preference for stabilizing inflation to achieve a given variability ratio.
Appendix II. Monetary Policy Regimes
| Primary Policy Objective | Nominal Anchor | Accountability Mechanism | Main Policy Instrument | Independence | |
|---|---|---|---|---|---|
| Brazil | Price stability | Inflation | If inflation breaches the target, the Governor is required to write an open letter to the Minister of Finance explaining the reasons for missing the target, as well as the measures and time frame to bring inflation back to target. | Collateralized overnight interbank rate target. | The Board of Directors consists of the Governor and eight Deputy Governors. The Governor is appointed by the President and does not have a fixed term. |
| Indonesia | Price stability | Inflation | Bank Indonesia (BI) submits quarterly monetary policy reports to the Indonesian Parliament. If the inflation target is missed, the BI will jointly with the government present an explanation before parliament and the public. | Overnight interbank rate target. | The Board of Governors consists of the Governor, a Senior Deputy Governor, and between four to seven Deputy Governors. The Governor and the Senior Deputy Governor are nominated and appointed by the President upon the approval of the House of Representatives. The Deputy Governors are nominated by the Governor and appointed by the President upon the approval of the House of Representatives. Members of the Board serve five-year terms and may be reappointed for one additional term. |
| Kazakhstan | Price stability | Exchange rate (U.S. dollar) | The National Bank of Kazakhstan (NBK) submits annual reports to the President for approval. | Issuing short-term notes and taking bank deposits, providing refinancing loans and conducting Repo operations. | The Supervisory Board consists of nine members. The Governor of the NBK, appointed by the President and approved by Parliament for a six-year term; five officials of the NBK, appointed and dismissed by the Governor; one representative of the President, appointed and dismissed by the President; and two representatives of the Government, appointed and dismissed by the Government. |
| Mexico | Price stability | Inflation | Banco de México (BM) sends to both the President and Congress: (i) a document setting out the monetary policy stance to be implemented in the current year in January; (ii) a report on monetary policy implementation in the preceding year in April; and (iii) a report on monetary policy implementation during the first half of the current year in September. In addition, the BM submits quarterly reports on inflation and economic development to Congress. Congress may also summon the Governor to report on BM’s policies and activities. | Overnight interbank rate target. | Members of the Board of Governors are appointed by the president, approved by the senate, and cannot be removed from their posts at the president’s discretion. The Governor serves for six years, starting in the middle of a six-year presidential term. The Deputy Governors serve for eight years and are replaced alternately every two years. |
| Malaysia | Price stability | Unspecified | The Board submits to the Minister of Finance annual reports. The report, along with the Bank’s financial statements, will be presented before the Senate and the House of Representatives. | Overnight interbank rate target. | The Board of Directors consists of the Governor, three Deputy Governors, and five other private- and public-sector representatives. The Governor is appointed by His Majesty for a term of five years. The Deputy Governors are appointed by the Minister of Finance for a term of three years. Other Directors are appointed by His Majesty on the advice of the Minister of Finance for a term of three years. Board members are eligible for reappointment. |
| Nigeria | Price stability and sustainable economic growth. | Broad Money (M2). | The Bank is required to submit to the President a report on its operations within four month from the close of each financial year, and submit to the President a copy of its annual accounts within two month after the close of each financial year. | Open market operations in T-bill market. | The Board of Directors consists of: the Governor and four Deputy Governors appointed by the President for a term of five years, five other members appointed by the President for a term of three years, and the Permanent Secretary of the Federal Ministry of Finance. |
| Saudi Arabia | Price stability (incl. exchange rate). | Exchange rate (U.S. dollar). | The Saudi Arabian Monetary Agency renders to the government, through the Minister of Finance, a copy of the half-monthly and annual statements. | Repo and reverse-repo rates. | The Board of Directors is chaired by the Governor, and consists of the Vice-Governor and three non-government officials. Board members are appointed for five years by a Royal Decree, in accordance with the nomination of the Minister of Finance and the approval of the Council of Ministers. Board members cannot be removed from office except by a Royal Decree issued in the same matter. |
| Turkey | Price stability. | Inflation. | The Governor of the Central Bank of Turkey (CBT) makes biannual presentations before the Council of Ministers and the Planning and Budget Commission of the Grand National Assembly to provide information about CBT activities and monetary policy implementation. If the CBT misses the inflation target, it is required to explain the reasons in writing to the Government, lay out the measures to be taken, and disclose the information to the public. | Benchmark one-week repo rate. | The Board consists of the Governor and six members to be elected by the General Assembly. The General Assembly consists of shareholders registered in the share book of the Bank. Board members serve a term of three years. One third of the members are renewed each year. Reelection of previous members is permitted. |
| Primary Policy Objective | Nominal Anchor | Accountability Mechanism | Main Policy Instrument | Independence | |
|---|---|---|---|---|---|
| Brazil | Price stability | Inflation | If inflation breaches the target, the Governor is required to write an open letter to the Minister of Finance explaining the reasons for missing the target, as well as the measures and time frame to bring inflation back to target. | Collateralized overnight interbank rate target. | The Board of Directors consists of the Governor and eight Deputy Governors. The Governor is appointed by the President and does not have a fixed term. |
| Indonesia | Price stability | Inflation | Bank Indonesia (BI) submits quarterly monetary policy reports to the Indonesian Parliament. If the inflation target is missed, the BI will jointly with the government present an explanation before parliament and the public. | Overnight interbank rate target. | The Board of Governors consists of the Governor, a Senior Deputy Governor, and between four to seven Deputy Governors. The Governor and the Senior Deputy Governor are nominated and appointed by the President upon the approval of the House of Representatives. The Deputy Governors are nominated by the Governor and appointed by the President upon the approval of the House of Representatives. Members of the Board serve five-year terms and may be reappointed for one additional term. |
| Kazakhstan | Price stability | Exchange rate (U.S. dollar) | The National Bank of Kazakhstan (NBK) submits annual reports to the President for approval. | Issuing short-term notes and taking bank deposits, providing refinancing loans and conducting Repo operations. | The Supervisory Board consists of nine members. The Governor of the NBK, appointed by the President and approved by Parliament for a six-year term; five officials of the NBK, appointed and dismissed by the Governor; one representative of the President, appointed and dismissed by the President; and two representatives of the Government, appointed and dismissed by the Government. |
| Mexico | Price stability | Inflation | Banco de México (BM) sends to both the President and Congress: (i) a document setting out the monetary policy stance to be implemented in the current year in January; (ii) a report on monetary policy implementation in the preceding year in April; and (iii) a report on monetary policy implementation during the first half of the current year in September. In addition, the BM submits quarterly reports on inflation and economic development to Congress. Congress may also summon the Governor to report on BM’s policies and activities. | Overnight interbank rate target. | Members of the Board of Governors are appointed by the president, approved by the senate, and cannot be removed from their posts at the president’s discretion. The Governor serves for six years, starting in the middle of a six-year presidential term. The Deputy Governors serve for eight years and are replaced alternately every two years. |
| Malaysia | Price stability | Unspecified | The Board submits to the Minister of Finance annual reports. The report, along with the Bank’s financial statements, will be presented before the Senate and the House of Representatives. | Overnight interbank rate target. | The Board of Directors consists of the Governor, three Deputy Governors, and five other private- and public-sector representatives. The Governor is appointed by His Majesty for a term of five years. The Deputy Governors are appointed by the Minister of Finance for a term of three years. Other Directors are appointed by His Majesty on the advice of the Minister of Finance for a term of three years. Board members are eligible for reappointment. |
| Nigeria | Price stability and sustainable economic growth. | Broad Money (M2). | The Bank is required to submit to the President a report on its operations within four month from the close of each financial year, and submit to the President a copy of its annual accounts within two month after the close of each financial year. | Open market operations in T-bill market. | The Board of Directors consists of: the Governor and four Deputy Governors appointed by the President for a term of five years, five other members appointed by the President for a term of three years, and the Permanent Secretary of the Federal Ministry of Finance. |
| Saudi Arabia | Price stability (incl. exchange rate). | Exchange rate (U.S. dollar). | The Saudi Arabian Monetary Agency renders to the government, through the Minister of Finance, a copy of the half-monthly and annual statements. | Repo and reverse-repo rates. | The Board of Directors is chaired by the Governor, and consists of the Vice-Governor and three non-government officials. Board members are appointed for five years by a Royal Decree, in accordance with the nomination of the Minister of Finance and the approval of the Council of Ministers. Board members cannot be removed from office except by a Royal Decree issued in the same matter. |
| Turkey | Price stability. | Inflation. | The Governor of the Central Bank of Turkey (CBT) makes biannual presentations before the Council of Ministers and the Planning and Budget Commission of the Grand National Assembly to provide information about CBT activities and monetary policy implementation. If the CBT misses the inflation target, it is required to explain the reasons in writing to the Government, lay out the measures to be taken, and disclose the information to the public. | Benchmark one-week repo rate. | The Board consists of the Governor and six members to be elected by the General Assembly. The General Assembly consists of shareholders registered in the share book of the Bank. Board members serve a term of three years. One third of the members are renewed each year. Reelection of previous members is permitted. |
References
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Cecchetti, Stephen G., and Michael Ehrmann, 2002, “Does Inflation Targeting Increase Output Volatility?: An International Comparison of Policymakers’ Preferences and Outcomes,” in Monetary Policy: Rules and Transmission Mechanisms, edited by Norman Loayza and Klaus Schmidt-Hebbel, 1(4), chapter 9, pp. 247–74.
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Jalali-Naini, A. R., and Mohammad A. Naderian, 2012, “Central Bank Lending, Inflation and Output Dunamics in a Limited Participation Model,” The Journal of Money and Economy, Vol. 7, pp. 41–66.
Mankiw, N.G., and Ricardo Reis, 2011, “Imperfect Information and Aggregate Supply,” in: Handbook of Monetary Economics, edited by Benjamin M. Friedman and Michael Woodford, 3A, pp. 183–229.
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Prepared by Robert Blotevogel and Yi Liu.
The subsidy reform entailed a combination of a simultaneous supply and demand shock. Unconditional cash transfers boosted households’ nominal, and depending on their consumption pattern, real incomes. Chapter 1 discusses the design and implementation of the first phase of the subsidy reform and draws lessons for future phases.
