A Projection of inflationary gap on the basis of P* model in Iran

Different economic schools have for long been discussing the relationship between money and price introducing different definitions of inflation on the basis of their particular views. However, it can be said that most of the economists unanimously believe that inflation in the long run is a monetary phenomenon. Iran has experienced different rates of inflation in the period between A. D. 1961-1998 A. H. (solar) 1340-1377. Several extensive studies were made in Iran to analyze this issue, most of which concentrated on monetary approach. In this paper we, too follow the monetary approach in our discussion of the subject relying on the recently introduced P * Model Method. Velocity and output gaps and the occurrence of financial innovations and major developments in money circulation (velocity) were used in making this study. First we try to apply the performance of the standard P * model in Iran. Then the extended P * model, in which both domestic and foreign price gaps are considered, will be examined. The Results of the study show that the domestic price gap cannot explain the inflation in Iran. The reason is that because velocity is unstable, it depends on volatility of exchange rate. Also, the output gap does not play a significant role in various versions of their inflation models. On the other hand, aggregate price gap and foreign price gap explain our inflation clearly and it can be said that foreign price gap has a crucial role in defining inflation.