The Effect of Institutional Quality on Business Cycle and the Dynamics of Macroeconomic Variables in Iran

Institutional quality is one of the key determinants of the economic performance of countries. The literature lacks a formal model to address the role of institutional quality changes in the macroeconomic dynamics of a developing economy. Using a new Keynesian dynamic stochastic general equilibrium framework and incorporating rent-seeking technology, this study investigates the effect of institutional quality shocks on the business cycle and the dynamic behavior of key macroeconomic variables in Iran. Our modeling allows us to show how institutional quality affects behavior of households, firms, government, and the central bank. The model is solved and calibrated for the period 1984-2017. The results indicate that better institutional quality increases private consumption, government spending, and non-oil production through increasing productive activities, decreasing transaction costs, improving productivity, enhancing investment, and promoting more effective monetary and fiscal policies. More specifically, policymakers should take certain measures to improve the quality of institutions in Iran through boosting government stability, fighting corruption, controlling rent-seeking activities, improving law and order, increasing democratic accountability, and bureaucracy quality. These findings might have important policy implications for policymakers in Iran.