The Relationship Between Exchage Rates and Inflation: The Case of Iran

Abstract

Iran is a country, which has experienced high, and chronic inflation period and fluctuating Exchange rates during past decades. After the revolution in Iran in 1979, followed by eight-year Iran-Iraq war and world oil crises, high inflation has been one of the Iran’s most important problems. Especially during past years boycotts against trade caused instable Exchange rates and high inflation in Iran. These issues attract economists’ interest toward this subject. Therefore, the aim of this study is to analyze the relationship between Exchange rate and inflation based on time series data, using Hendry General to Specific Modeling method and Vector Autoregression (VAR) model. To this end, we used annual data for the period 1976-2012 for Hendry method. We also used the quarterly data between 1997: 3 - 2011: 4 to estimate VAR model. Due to economic instability in recent years and lack of valid data we estimated model up to 2012. As a result of the Hendry model, it is obtained that there is a direct relationship between Exchange rate and inflation. An increase in foreign exchange rates makes the inflation goes up. By including the money supply variable to VAR model the effects of money supply and the exchange rate on inflation has been investigated as well. According to the results, both the money supply and the exchange rate affect the inflation in the positive direction. Contribution of the money supply on inflation is greater than the exchange rate.

Keywords: Exchange Rate, inflation, Hendry Method, Time Series, VAR model