Empirical Analysis of Existence of the Mundell's Relationship between Interest Rate and Inflation in Iran: A State-Space Approach

The relationship between interest rate and inflation has always been one of the most important issues in the monetary economics and determining the nature of this relationship can have significant effects on economic policy making. Therefore, the aim of this paper is to investigate the relationship between interest rate and inflation in Iran. In this research, the accuracy of Fisher effect and its theoretical alternative, the Mundell effect, have been investigated. In economic literature, there is a positive relationship between the nominal interest rate and expected inflation. This effect, which was introduced by Irving Fisher in 1930, became known as the Fischer effect. According to this theory, an increase in the expected inflation rate will increase the nominal interest rate but the expected real interest rate will remain unchanged.
Mundell (1963) argues that inflation can be continuously lower than real interest rates. In this case, wealth holders redistribute their portfolio and save less money and more interest-bearing assets. Also, by accepting the assumption that consumption is a function of the interest rate, people will reduce their consumption. Simply, an increase in money growth leads to an increase in inflation, and an increase in inflation increases the cost of money opportunity. As a result, it decreases the real balance of money and increases the demand for interest-bearing assets. Because money is a part of wealth, wealth also will be decreased, and reducing wealth reduces consumption and increases savings. In this study, Time Varying Parameters method has been applied. The reason of using TVP approach is that this method incorporates Lucas critique in estimation of parameters and as a result, it can decrease the biased estimations. Therefore, by designing a state-space model for nexus interest rate and inflation, this relationship has been estimated by the Kalman filter method during the period of 1973-2015. For ensuring the robustness of results, two different dependent variables have been applied one of which is the mean of one to five years’ interest rates and the other one is the rate of return of housing sector. The estimation results indicate that random variable parameters of the inflation in the Fisher equation from the 1970s to the late 1980s and early 1990s have been ascending and upward, with the coefficient from about 0.02 in 1991 to about 0.28 in the year 2011. Thus, an increase has been seen in the weight of the inflation factor over the past two decades in determining the banks' interest rate by the monetary authorities of the country. However, in this direction between 2005 and 2007, the rising trend of inflation in determining the rate of interest on bank services had a downward and reversal trend. This was due to the new government's implementation and the determination of bank profits regardless of inflation, but from 2008 to 2011, the inflation rate has been decisive in determining the bank's interest rate. In the year 2012, the trend was also lower due to the start of banking and oil sanctions, which led to a high inflation away from the nominal rate of bank profits. But in the years 2012 to 2015, the upward trend in the inflation rate has been increasing in determining the rate of interest on the bank with a growing trend. It is one of the reasons the new government used to determine the rate of interest based on inflation rate in 2013. The results also show that in the 1970s, the process of determining inflation in the rate of interest on bankrolls has become increasingly rooted in the trend, which has been decreasing since the beginning of the 1980s and during the years 2001-2004. Furthermore, the rate of return of housing, rather than the nominal rate of bank earnings, shows the coefficient of inflation in determining the rate of return of housing has been upward. Therefore, in total, it can be said that Mundell's relationship has been established in Iran. Of course, it is necessary to note that this relationship has gone up and, in the long run, the relationship has been tightened and moved towards the Fisher relationship in which the money is neutral. This pattern shows that economic activists are gradually paying more attention to real interest rates. However, in the way that has been investigated, the money has not been neutral, and changes in inflation have led to changes in the real interest rate. The consistency of this relationship with Mundell's vision means that the increase in the expected inflation rate will reduce the real money back, and, as a result, wealth will be decreased. Decrease in wealth reduces consumption and increases savings, which indicates that a unit of increase in expected inflation will reduce real interest rates and the effect of expected inflation on nominal interest rates will be less than one, thus, monetary policy changes are not neutral and effective on real variables.