How Should the Central Bank Deal with Chronic Inflation in Iran?

Central banks usually face difficulties in making distinction between the steady state component of price indices and their cyclical terms when they try to set targets for inflation. This is important because CPI as a whole does not properly reflect the impacts of fiscal and monetary policies. A measure to reveal the inflationary impacts of policies is therefore needed. The common statistical methods that single out core inflation are not necessarily consistent with economic theories. The Quah-Vahi method, based on the long-run vertical Philips curve, is applied in the current paper to a SVAR model that employs the bi-variate quarterly series of inflation and real output during 1370-87 to identify the permanent and transitory parts of inflation in the Iranian Economy. We then argue that given tradeoffs among the macroeconomic goals, mitigating the permanent component of inflation is costly due to the stable political equilibrium that currently exists in Iran between the government, public and the central bank. The paper thus proposes reducing the cyclical component of inflation that mitigates the inflation in addition to boosting real output.