The Effects of Budget Deficits Structure on Liquidity in Iran's Economy: A Central Bank Reaction Function Approach

The chronic budget deficits and dominance of government fiscal status on monetary sector are the characteristics of Iran’s economy after the revolution. Based on the economic literature, these characteristics explain the continuous and considerable variations of money supply in the country. Using the VARX model, this paper aims at the impact of budget deficits structure on the liquidity based on the central bank reaction function during the period of 1979-2010. The results indicate that changes in the budget deficits and liquidity are not necessarily in the same direction. Increasing the operating budget deficits by the government, which indicates its current operations, leads to an increase in the budget deficits and liquidity. However, the changes in net acquisition of nonfinancial assets, which is mainly influenced by the oil market, despite the change of the budget deficits, do not affect liquidity.
Therefore, the operating budget deficits, and not necessarily the budget deficits or the net acquisition of nonfinancial assets, are a spur for liquidity changes in the short run and long run. Also, the oil market disturbances have no permanent effects on liquidity by themselves. Then, budget reforms based on small and flexible operating budget deficits, cyclical balanced operating budget deficits and reduction of the dominance of budget on the banking system must be pursued for to successfully curb the inflation.