The Relationship between Inflation and Money in Iran: Evidence from P* Model

This paper tests monetary view of inflation in Iranian economy by a monetary approach within P* model using OLS and ARDL techniques during 1358-1387 (1979-2008). It should be noted that only the standard P* model (domestic price gap) is tested in this study. Regarding that domestic price gap consists of output and velocity gaps, the Hedrick – Prescott filter method is used to estimate the potential production level and the velocity of balanced money. Estimation results of various models show that the standard P* model (domestic price gap), is not able to explain and forecast inflation in Iranian economy and implies that the quantity theory of money is not correct in Iranian economy. Therefore, we investigated monetary theory of inflation using alternative variables including volume of liquidity, real gross domestic product (GDP), informal exchange rate, import price index with using ARDL method. Results show that a 10% growth of liquidity leads to increase general prices by 4.6%. Thus, the monetary hypothesis of inflation is partially confirmed, however concerning that relationship between inflation and liquidity volume is not unique, and other factors affect inflation in Iran, therefore to curb Iranian inflation we cannot adopt only monetary policy as an effective tool.