Budget deficit and the inflationary process in the Islamic Republic of Iran (1963-2002)

Abstract

The budget deficit issue has attracted a great deal of attention over the past two decades, as reflected in substantial in the academic literature and in the policy making community. Moreover, the budget deficit and related issues has become a major problem facing the Iranian economy. The main objectives of this study are as follows: First, to macro model prospective developments in the Iranian economy for policy analysis and evaluation. The main purpose of this study is to develop a dynamic macroeconomic model to examine the effect of budget deficit, liquidity (M2), official exchange rate and political factors on inflationary process in Iran during 1963-2002. The second objective of this study is to analyse the economic trends and macroeconomic policies in Iran over the period of investigation. To make that judgment, it analyses public sector deficit, monetary development, and inflation with consideration of political factors such as the 1979 revolution, the 1980-1988 war with Iraq, and the economic reform programme after war. Many economists have studied the relationship between budget deficit, money supply and inflation in both developed and developing countries. They have used various econometric models to estimate the relationship between budget deficit and inflation. There are two group studies, in first group, budget deficit variable is directly entered into the model and the relationship with inflation has been studied, second group has indirectly studied the relationship between budget deficit and inflation. This study has also directly studied the relationship between budget deficit and inflation. The selection of variables for our baseline model is based on the following consideration. First, to measure the price inflation, the consumer price index (CPI) is included in the baseline model. Second, we included the budget deficit and liquidity (M2) in the price equation together following Choudhary and Parai (1991). In fact, these variables are used to allow for the effects of fiscal and monetary policies on price level. Third, we also included the official exchange rate in model following Piontkivsky et al. (2001) to detect the effect of exchange rate policy on price level in Iran.