Inflationary Effects of the Foreign Currency Shocks with Different Sources: The Response of Monetary Policy in a Developing Economy

The inflation rate has constantly been volatile in Iran’s economy. At the same time, the considerable fluctuations in the foreign exchange market, the inflationary environment and its impact on inflation expectations, the role of the central bank, and whether or not expectations are consistent with monetary policy indicate a likely correlation between these variables. Therefore, this study aims to investigate separately for different real sectors of an economy during the periods 2001:1-2010:4 and 2011:1-2018:4 whether Iran’s economy was exposed to foreign currency shocks with domestic and external sources. Moreover, the responses of monetary policy to these shocks were examined using the vector autoregressive method (VAR). The results showed that the price index of all commodity groups increased in response to foreign exchange shocks, regardless of domestic or external sources. The inflationary effects of foreign currency shocks with domestic sources persisted in the medium and long term, while the inflationary effects of foreign exchange shocks with external sources were moderate in the medium term and neutralized in the long term. In addition, the speed of corrections in the deviation from a long-term equilibrium has significantly been greater after the shock of international economic sanctions than the policy of exchange rate unification. Monetary policy was expansionary and strengthened after the occurrence of the domestic-source foreign shock, and inflation expectations did not move in the same direction. On the other hand, monetary policy was contractionary and moderated the inflationary impact of the foreign currency shock, and inflation expectations went in the same direction.