Mohammad Nikzad; Mahdi Yazdani; Hassan Dargahi
Abstract
Balance of payments shocks can impact economies in varying degrees depending on their structural characteristics, often leading to the formation of business cycles. These cycles cause key macroeconomic variables, such as output, inflation, and exchange rates, to deviate from their long-term trends. ...
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Balance of payments shocks can impact economies in varying degrees depending on their structural characteristics, often leading to the formation of business cycles. These cycles cause key macroeconomic variables, such as output, inflation, and exchange rates, to deviate from their long-term trends. The exchange rate policy and regime play a critical role in determining how these shocks propagate and generate business cycles. This research employs a dynamic stochastic general equilibrium (DSGE) model to evaluate the effects of different balance of payments shocks—including oil exports, non-oil exports, and terms of trade shocks—on major macroeconomic variables in Iran under various exchange rate regimes (ERRs). Using welfare loss criteria and impulse-response functions, the findings indicate that a fixed real ERR results in the least welfare losses under different balance of payments shocks. Additionally, a managed floating ERR performs better than a floating ERR, whereas a fixed nominal ERR incurs the greatest welfare losses. The results also suggest that minimal central bank intervention minimizes the recessionary impact of negative shocks in the short run, although it leads to higher inflationary effects.
Introduction
Generally, due to the impact of balance of payments shocks in creating business cycles, the existence of equilibrium in the balance of payments is considered one of the important indicators of macroeconomic stability. One significant channels through which these shocks affect business cycles is the real exchange rate channel, and thus, the exchange rate policy is crucial. Also, in Iran as an oil-dependent economy, due to the role of oil revenues in the government's general budget, industrial production relies on foreign currency income from oil exports to import intermediate and capital goods. Therefore, examining foreign exchange rate policies is particularly important. The primary purpose of this study is to evaluate the role of foreign exchange rate policies in transferring balance of payments shocks to aggregate output and business cycles. For this purpose, a dynamic stochastic general equilibrium model (DSGE) is used to evaluate and compare the effects of balance of payments shocks (including oil export shock, non-oil export shock, and the term of trade shock) on macroeconomic variables and especially in creating business cycles in different Exchange Rate Regims (ERRs).
Methods and Material
The main framework of the DSGE model in this study is taken from the studies of Adolfson et al. (2007), Gekain and Kulikov (2009), Balke and Brown (2018) and Tavaklian and Jalali Naini (2016), which are based on the topic and questions of the research and has expanded according to the structure of Iran's economy. Based on this, the model includes the household sector, producer sector, labor market, government sector, central bank, as well as trade sector including export, import, and balance of payments account components. Also, before simulating different shocks, the calibration method will be used to calibrate the model parameters as suggested by Chen et al. (2012) and Angelopoulos et al. (2010). The time series of all macroeconomic variables were extracted from economic databases such as the Central Bank of Iran and the Statistical Center of Iran, with their average calculated as steady-state parameters. Finally, examining and comparing the moments of the actual data of the Iranian economy with the moments obtained from the introduced model, indicates the relative success of the model in the Iranian economy.
Results and Discussion
In the framework of different ERRs, the effects of negative shocks (equal to 10% on oil exports, non-oil exports and the term of trade) have been investigated and the results are compared based on the welfare loss function in Table (1). Generally, the welfare loss function is the weighted sum of output, inflation and real exchange rate variances that indicates the weighted sum of instability in important macroeconomic variables due to temporary negative shock, which is calculated for the entire period from short-term to long-term. Therefore, the question is, in which of the ERRs, the vulnerability of the macroeconomic is less against negative shocks? The important findings are as follows:
The prioritization of ERRs with the aim of reducing the effects of negative shocks, is the same in all three negative shocks of oil, non-oil exports and the term of trade. The welfare loss resulting from shocks is the highest in the fixed ERR and the lowest in the fixed real ERR. After the fixed ERR, the floating and the managed floating ERRs have more welfare losses, respectively.
In the short-run, as compared to the floating ERR, a negative shock with the deterioration of the balance of payments, leads to less inflation but more recession in the fixed ERR. However, in the whole period, the loss of the fixed ERR is more than the floating one.
In the short-run, as compared to the floating ERR, the negative shock in the managed ERR with the deterioration of the balance of payments, leads to less inflation and recession. In the whole period, the welfare loss of the managed ERR is less than the floating ERR.
In the short-run, a negative shock in a fixed real ERR, compared to a managed floating ERR, leads to more inflation and less recession. However, in the whole period, the loss of the fixed real ERR is less.
If the level of intervention of the central bank in the foreign exchange market is classified from the highest to the lowest, we will have the fixed, the managed floating, the fixed real exchange rate, and the floating ERRs, respectively. The results of the model show with the lowest central bank's intervention, the recessionary effect of the negative shock is lower, but the inflationary effect is greater in the short-run.
Due to the dependence of the trade structure and government budget on oil revenues in Iran's economy on the one hand, as well as the ownership and supply of foreign currency resulting from oil exports by the government and other assumptions of the research model, fixed and floating exchange rate policy rules are not recommended. Rather, the fixed real exchange rate and managed floating ERRs have relatively fewer losses, respectively. Although one of the essentials of the successful implementation of the managed floating ERR against negative shock, is the possibility of sufficient foreign exchange reserves of the central bank to intervene in the foreign exchange market to eliminate short-run fluctuations.
In all ERRs, the negative shock of oil export has the largest welfare loss compared to other impulses.
Table 1 Comparing the Welfare Losses of the Impulse Response Functions of Shocks in Different Exchange Rate Systems
Shock
ERRs
Variance
Welfare Losses
Output
Inflation
Real Exchange Rate
Oil-export
Fixed
0.3893
0.0316
1.19
0.5234
Floating
0.0119
0.116
1.21
0.4028
MF
0.0414
0.0075
0.184
0.0740
FR
0.0144
0.0054
0
0.0162
Non-Oil-Export
Fixed
0.0058
0.0007
0.0156
0.0072
Floating
0.0002
0.0004
0.1016
0.0037
MF
0.0014
0.0003
0.0051
0.0022
FR
0.0006
0.0005
0
0.0007
Term of Trade
Fixed
0.0066
0.0007
0.0719
0.0082
Floating
0.0002
0.0004
0.0107
0.0034
MF
0.0018
0.0004
0.0067
0.0028
FR
0.0009
0.0006
0
0.0010
*MF and FR refer to Managed Floating and Fixed Real Exchange Rate Regime, respectively.
Source: Research Findings
Conclusion
Based on the results, the oil export shock has the greatest impact on the welfare loss, making it a high priority to create a stable trend in income from oil export. Policymakers should prevent the occurrence of a strong shock in the amount of injected foreign currency, in order to create stability in the production process. This can be done with the currency stabilization fund within the framework of the National Wealth Fund. Oil shocks can also affect the exchange rate, so it is necessary to control the oil shocks to prevent the exchange rate fluctuations. It should also be noted that non-oil export shock causes business cycles and welfare losses. Therefore, the policymakers should pay attention to the diversification of production and exports. Stabilization of foreign exchange income from oil and non-oil exports on the one hand, and the expansion of domestic production on the other hand, leads to the reduction of welfare losses caused by various shocks in the balance of payments.
