Oil Shocks, Institutional Quality Change and Macroeconomic Dynamics in Iran

The interaction between institutional quality and the mechanism of oil shock diffusion might have a significant effect on macroeconomic dynamics in an oil-exporting country. The literature lacks a formal model to address the role of institutional quality in the economic performance of an oil-rich developing economy. Using a new Keynesian dynamic stochastic general equilibrium (DSGE) framework, this study develops a model to investigate the response of macroeconomic variables to changes in institutional quality resulted from oil shocks in Iran as an important oil-exporting country. Our modeling allows us to show how institutional quality and oil revenues affect households, firms, government, and the central bank. The model is solved and calibrated for the period 1959-2017. The results indicate that the destruction of institutional quality caused by a positive oil shock prevents the Iranian economy from reaping the fruits of an increase in oil revenues. Oil revenues and their shocks by destroying the institutional quality through the expansion of rent-seeking ‎activities, increasing transaction costs of production, reducing the impact of government spending, and ‎diverting monetary and fiscal policies from the targets result in negative effects on Iranchr('39')s non-oil ‎production in the long run.‎ To reduce the destructive effects of oil shocks on institutional quality in the Iranian economy, we suggest the policymakers in Iran reduce the dependency of the government budget on oil revenues.