Modeling exchange rate and economic sanctions against Iran utilizing the Markov switching method

Exchange rate stability in the market plays a key role in both competitiveness and as far as reducing economic uncertainty. The exchange rate in Iran has been fluctuating for several years now due to political factors, specifically economic sanctions. Utilizing the Markov switching method, this study has endeavoured to model the direct effects of sanctions on the exchange rate and the indirect impact of sanctions and inflation on the exchange rate between 1985-and 2021. The exchange rate in Iran is dual in nature, meaning there are two systems that govern it: 1-Characterized by low average exchange rates and high standard deviation; 2-High average inflation and low standard deviation. Hence, in this article, two models specified by Markov switching shall be used. The findings reveal the probability of staying in the low exchange rate system is higher than the probability of remaining in the high exchange rate one. In addition, the probability of transition from the low exchange rate system is higher than the opposite probability (due to the stability of the low exchange rate in the country). The findings also show that sanctions have a low and positive effect on the exchange rate. Moreover, the impact of inflation on the exchange rate is positive.