Document Type : Research Paper
Authors
1 Ph.D. Student in Economic Sciences, Department of Economics, Faculty of Economics and Political Sciences, Shahid Beheshti University, Tehran, Iran
2 Professor, Department of Economics, Faculty of Economics and Political Sciences, Shahid Beheshti University, Tehran, Iran
3 Associate Professor, Department of Economics, Faculty of Economics and Political Sciences, Shahid Beheshti University, Tehran, Iran
4 Associate Professor, Department of Economics, Faculty of Economics, Allameh Tabataba’i University, Tehran, Iran
Abstract
To achieve the optimal monetary policy, attention must be paid to a key element: the credibility of monetary policy authorities. Credibility plays a crucial role in the effectiveness of these policies, as it facilitates the attainment of targeted variables with minimal fluctuation and social cost. Conversely, in times of unexpected economic shocks, discretionary policy becomes optimal, providing policymakers with flexibility to make appropriate monetary decisions.
Conversely, in times of unexpected economic shocks, the use of discretionary policy is optimal because it provids policy makers with more flexibility to make appropriate monetary decisions. In this study, we pursued two goals. First, we constructed a Dynamic Stochastic General Equilibrium (DSGE) model for an open and small economy according to the conditions of Iran's economy. We then estimated the of credibility of Iran’s monetary policy authority in managing both the inflation rate and exchange rate yielding figures of0.1019 and 0.0099 respectively. Then, in order to find the optimal discretionary monetary policy under the influence of two scenarios of low and high credibility of the monetary policy authorities, we utilized the minimum loss function approach. The results of the model indicated that the credibility of the monetary policy maker in Iran is very low in both the inflation rate and the exchange rate. Examining the loss function of the central bank showed that, in both scenarios, minimizing the exchange rate gap while assigning equal weight to other objectives leads to the lowest possible loss function value.
Introduction
The optimal monetary policy is the maximization of welfare or the minimization of social loss of economic factors that are applied according to the constraints governing a society. A very important point that governments should consider when implementing their economic policies is the ability of central banks to influence key macroeconomic variables through the implementation of these policies. The key element in the effectiveness of these policies is the credibility of the monetary policy authorities. The credibility of the monetary policy authorities depends on various factors and components, the most important of which is his commitment and ability to achieve well-defined goals. From the point of view of central banks and economists, the credit of the policymaker is important because it helps to achieve the variables targeted by the central bank with the least amount of volatility and the least social cost. The credibility of the authorities is an exogenous variable that the politician cannot influence quickly because the credibility, depends on his past behavior and his success rate in achieving the goals that he has clearly set. In this study, for the first time in the studies conducted in Iran, monetary policy was considered discretionary, and with the DSGE model, we estimated the credibility of the policymaker in the two fields of inflation and exchange rate. The difference between this study and other studies conducted so far considering the discretionary policy is that they had always first considered a rule for policy making, and then, in a discretionary policy, the parameters estimated with the assumption of the rule have been used, but in this study, no rule has been considered for monetary and exchange rate policy. After estimating the credit value of the policy authority, we entered the credit values of monetary policy authority in the central bank's loss function, which is also done for the first time in Iran.
In this research, we seek to answer the following questions:
How much is the credit of the monetary policy authority in the field of inflation rate and exchange rate in Iran?
Optimal monetary policy by considering the credit of the monetary policy authorities, in which weights will be obtained from the central bank's loss function?
Method
In this research, we used a DSGE model for an open and small economy and we tried to adjust all parts of the model according to the conditions of Iran's economy. Then by using the Bayesian approach, we estimated the values of the model's parameters, including the credibility of the policy authorities. At last, we used the loss function approach to obtain the optimal monetary policy.
Results and Discussion
We obtained the values of the variables using the Bayesian method. The obtained values for the credibility coefficient in the two fields of inflation rate and exchange rate were obtained as 0.1019 and 0.0099, respectively. In order to check the validity of the estimates, the Geweke (1992) test was used, which makes the calculations much less and faster than the Brooks & Gelman test. Then we used an identification test to determine the values of 𝛻 and ∇_e. Since these parameters could not be identified, we had to calibrate and analyze their sensitivity. The estimation results showed that the credibility of the monetary policy maker in Iran is low in both the fields of inflation and exchange rate and it is worse in the field of exchange rate.
In pursuit of finding the optimal monetary policy in discretionary policy, by assigning different weights to the goals of the central bank, under two scenarios of low and high credit of the monetary policy maker, we try to obtain the minimum amount of the loss function. The results are reported in tables (1) and (2).
In both scenarios, the examination of different weightings to the coefficients of the central bank's goals in the loss function shows that in the case where the monetary policy authorities give the higher weight to the reduction of the exchange rate gap and equal weight for all three other goals, the amount of loss function of the central bank is less and in the scenario of low and high credit of the policy authority is equivalent to 0.0030 and 0.0036 respectively. Perhaps the reason for this can be found in the oil structure of Iran's economy.
Conclusion
We designed a DSGE model for Iran's economy and we estimated the amount of credibility of the monetary policy authority in two fields of inflation rate and exchange rate which are very low. Then, in order to find the optimal discretionary monetary policy under the influence of two scenarios of low and high credibility of the monetary policy authorities, we used the approach of the minimum value of the loss function. To further investigate the model, we analyzed the impulse and response functions for the main variables of the model to productivity shocks, government spending and oil price inflation in two scenarios. In all the input impulses, we found that the high credit of the monetary policy authority causes fewer fluctuations in the key variables of the model compared to the low credit of the policy maker. The results show that when the policymaker has a favorable reputation, the members of the society consider the effects of shocks to be temporary and do not anchor their decisions to it; therefore, even if the policy authority does not implement a specific policy to mitigate the effects of the shock, the variables will stabilize faster than when the credibility of the monetary policy maker is low.
Table 1. Variance values of key variables and loss function in different weights to different objectives of the central bank based on the low credibility of the monetary policy maker in Iran
Loss function
The growth rate of money
Exchange rate
Production
Inflation
0.0057
0.0107095
0.000108
0.048874
0.000255
0.000121
0.199880
0.552274
0.000061
1
1
1
1
0.0032
0.010878
0.000037
0.049181
0.000239
0.0001238
0.200963
0.556854
0.000071
0.5
1
0.5
1
0.0031
0.010837
0.000114
0.049003
0.000247
0.000120
0.200429
0.552450
0.000062
0.5
0.5
0.5
1
0.0032
0.010598
0.000136
0.048443
0.000271
0.000124
0.197112
0.547030
0.000030
0.5
0.5
1
0.5
0.0030
0.010839
0.0000234
0.049070
0.000245
0.000125
0.200483
0.557180
0.000070
0.5
1
1
0.5
Source 1: research findings
Table 2. Variance values of key variables and loss function in different weights to different objectives of the central bank under the high credibility of the monetary policy maker in Iran
Loss function
The growth rate of money
Exchange rate
Production
Inflation
0.0071
0.010910
0.000020
0.049181
0.000252
0.000125
0.200867
0.554519
0.000075
1
1
1
1
0.0043
0.010992
0.000007
0.049283
0.000243
0.000124
0.201188
0.552829
0.000086
0.5
1
0.5
1
0.0042
0.010975
0.000023
0.049214
0.000244
0.000122
0.201013
0.550374
0.000079
0.5
0.5
0.5
1
0.0040
0.010738
0.000028
0.049063
0.000270
0.000128
0.199280
0.553586
0.000028
0.5
0.5
1
0.5
0.0036
0.010928
0.000006
0.049252
0.000248
0.000127
0.201052
0.557054
0.000081
0.5
1
1
0.5
Source 2: research finding
Keywords
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