Expectations Trap of Discretionary Monetary Policies: Fiscal Domination in Iran

Discretionary policies, lead to the expectations traps and multiple equilibria in economy, which could be the most important causes of persistent inflation. This study by using a micro foundation general equilibrium investigates expectations traps of discretionary monetary policy in dominant fiscal policy condition. Our calibrated model shows that the interest rate in these conditions is about 2.5 times greater than the rate of interest achieved by the assumption of independent monetary policy. This result shows the amount of effect of taking advantage of discretionary monetary policy, with the aim of achieving government budget, on increasing the equilibrium interest rate. This increase consequently raises the equilibrium inflation rate and results in persistent inflation traps in the economy. The model was also calibrated using data from Iran. The results show that equilibrium of Iran's economy will be achieved at the interest rate of 12%. In other words, in the interest rate of less than 12%, the benefit of inflation is more than the cost of inflation distortion.