# The Effects of Oil Price Shocks on Monetary Policy in Iran

**ABSTRACT** Changes and increases in the price of oil are effective on the aggregate economic. So, it's important to study on oil price shocks, because they affect on economic growth & monetary policy.In this paper a structural and generalized VAR models has been considered for Iran in order to study the direct effects of oil price shocks on output and prices and reaction of monetary variables to external shocks over the period 1991:I–2008:I (1370:I_1386:IV). Empirical analysis shows that inflation rate increase and exchange rate decrease and gross domestic product has fluctuations.

**0**

**0**

**·**

**0**Bookmarks

**·**

**37**Views

- Citations (1)
- Cited In (0)

- [show abstract] [hide abstract]

**ABSTRACT:**In this paper we study the oil prices-macroeconomy relationship by means of studying the impact of oil price shocks on both economic activity and consumer price indexes for six Asian countries over the period 1975Q1-2002Q2. The results suggest that oil prices have a significant effect on both economic activity and price indexes although the impact is limited to the short-run and more significant when oil price shocks are defined in local currencies. Moreover, we find evidence of asymmetries in the oil prices-macroeconomy relationship for some of the Asian countries.05/2004;

Page 1

Electronic copy available at: http://ssrn.com/abstract=1551484

The Effects of Oil Price Shocks on Monetary policy in Iran

Ebrahim Siami1

Fatemeh Fahimifar2

ABSTRACT

Changes and increases in the price of oil are effective on the aggregate economic. So, it's important to study on oil

price shocks, because they affect on economic growth& monetary policy.

In this paper a structural and generalized VAR models has been considered for Iran in order to study the direct

effects of oil price shocks on output and prices and reaction of monetary variables to external shocks over the

period 1991:I–2008:I (1370:I_1386:IV). Empirical analysis shows that inflation rate increase and exchange rate

decrease and gross domestic product has fluctuations.

Keywords: Oil price shocks, Monetary policy

JEL: E31, E32

1 M.A. Students economics sciences, Islamic Azad university, central Tehran branch, "IRAN" ebrahimsiami@gmail.com

2 MA. Students economics sciences, Islamic Azad university, central Tehran branch, members of young researchers club.

"IRAN", Fatemeh_fahimifar@yahoo.com

Page 2

Electronic copy available at: http://ssrn.com/abstract=1551484

INTRODUCTION

Among the shocks related to supply process, the shock of oil price is one of the most important factors that have

affected the world economy since 1970s.(Abrishami and other(2006)). Increase in the oil price during recession,

escalation in the rate of unemployment and inflation, and aggravation in the budget deficit problems, have

affected many oil importer Countries Yet, on the other hand the mark-up on oil in an oil producing country like

Iran, leads to increase in the State revenue and helps the government pursue and go on with its development

projects; although, since Iran is contented with selling crude oil, and it imports commodities and oil products from

other Countries, this will lead to increase in the price of the oil products as a result of mark-up on crude oil.

However, capability of the Country to reduce the consumption of these products and to resort to other domestic

sources of energy, for their low prices, and the level of dependence on imported oil products, can double the

vulnerability of the State. The aforementioned factors and the lack of adequate independency of the Central Bank

are instrumental in inflation of the Iran’s economy. As it is illustrated by Diagram No. 1, the Country has

experienced two different kinds of inflationary policy during the past decades. During the execution of the first

inflationary policy, from 1959 to 1973(1340to1352), prices rose at low level and on one figure basis and were

quite more stable with less fluctuation During the execution of the second inflationary policy, which has been

continuing from 1974(1353) to the present time, the two figure increase in the prices was at high level, instable

and far more fluctuating. It should be notified that, the inflation rate was in increasing process till 1995(1374) and

started to decrease since 1996(1375), yet still fluctuation

Fig.1 inflation

Source: Iran central bank

When the State economy faces an oil price shock, the role of the Central Bank gets more significant; that is, the

Central Bank should take actions to stable the inflation rate and to commence producing, which are very difficult

tasks to deal with. In this situation if the Central Bank starts to reduce the interest rate to prevent the actual rise in

GDP that will increase rate.

and on the other hand if the Central Bank policies aim at controlling the inflation, the economy will face growth

reduction.(Nota Di Lavoro(2005)).

This matter is also true in Iran’s economy; however, the only existing difference is that the growth of Iran’s

economy does not fall because of increase in the oil price. the Central Bank tries to decrease the interest rate to

protect home industries, and this policy intensifies the inflation pressure, because of inequality of the inflation

rate with the interest rate which is mainly for the interest rate is prescribed and ordered.

Page 3

Fig.2 Gross domestic product

Source:Iran central bank

As it is illustrated in the above diagram, the economy growth of Iran is deeply depending upon oil income.

Recession period and boom of the State economy growth process are directly and indirectly affected by the rise

and fall of oil price. For instance, during 1982(1361) and 1983(1362) when the Country was struggling with the

war (Iran- Iraq), there can be found the two figure rate of economy growth and a great deal of increase in the oil

income; however, during the ending years of the war1988(1367), the economy growth reduced severely, because

of decrease in oil price and oil income as a result.

LITERATURE REVIEW

Study of Ch. Kamps and Ch. Pierdzioch)2002) has entitled," Monetary Policy Rules and Oil Price Shocks ".

their analysis shows that it is important to distinguish between alternative price indices (CPI, core CPI, and GDP

deflator) when modeling the effects of oil price increases. their results demonstrate that targeting the change in the

GDP deflator is an inferior monetary policy strategy in the presence of oil price shocks. Study of K. Lee and Sh.

Ni(2002), has entitled " On the dynamic effects of oil price shocks: a study using industry level data" This paper

analyzes the effects of oil price shocks on demand and supply in various industries whit VAR models. The result

show for many other industries, with the automobile industry being a particularly important example, oil price

shocks mainly reduce demand. The paper suggests that oil price shocks influence economic activities beyond that

explained by direct input cost effects, possibly by delaying purchasing decisions of durable goods. Study of J.

Cunado and F. Perez de Gracia(2004), has entitled " Oil prices economic activity and inflation: evidence for

some Asian countries", they studied for six Asian countries over the period 1975Q1–2002Q2. The results

suggested that oil prices had a significant effect on both economic activity and price indexes, although the impact

was limited to the short run and more significant when oil price shocks are defined in local currencies and found

evidence of asymmetries in the oil prices–macro economy relationship for some of the Asian countries. Study of

R. Jiménez-Rodríguez , M. Sanchez(2004), has entitled " Oil Price Shocks and Real GDP Growth: Empirical

Evidence for Some OECD Countries", This paper estimated Multivariate VAR analysis is carried out using both

linear and non-linear models. They found evidence of a non-linear impact of oil prices on real GDP. Among oil

importing countries, oil price increases are found to have a negative impact on economic activity in all cases but

Japan. Moreover, the effect of oil shocks on GDP growth differs between the two oil exporting countries in their

sample, with oil price increases affecting the UK negatively and Norway positively. Study of J. Cunado and F.

Perez de Gracia(2004), has entitled " Oil prices economic activity and inflation: evidence for some Asian

countries", they studied for six Asian countries over the period 1975Q1–2002Q2. The results suggested that oil

prices had a significant effect on both economic activity and price indexes, although the impact was limited to the

short run and more significant when oil price shocks are defined in local currencies and found evidence of

asymmetries in the oil prices–macro economy relationship for some of the Asian countries. Berument and

Ceylan (2005) examined how oil price shocks affect the outputgrowth of selected Middle East and North African

countries that are either exporters or net importers of oil commodities. In this respect, they used a structural

Page 4

vectorautore-gressive (SVAR) model, focusing explicitly on world oil prices and the real GDP over the period of

1960-2003. Their impulse response analysis suggests that the ef-fects of the world oil price on GDP of Algeria,

Iran, Iraq, Jordan, Kuwait, Oman, Qatar, Syria, Tunisia and UAE are positive and statistically significant.

However, for Bahrain, Egypt, Lebanon, Morocco and Yemen they did not find a significant impact on oil price

shocks. Study of M. Mehr ara and K. Niki oskuee(2006) has entitled, "oil impacts and its dynamic effects for

variable macroeconomic". The SVAR model was used in this article and for to introduce structural impacts of

Blanchard was used long run limitation approach. The result of this estimate for Iran was compared with three oil

exporting countries(Indonesia, Kuwait and Saudi Arabia, Countries with same economics conditions) in 1960-

2003. analyzing data was done by FEVDs and IRFs. . the results show that, external degree of oil price in both

Kuwait and Saudi Arabia is less than Iran and Indonesia. moreover, the impact on oil price have been the main

reason of change in GDP and imports in Iran and Saudi Arabia, as the impact on imports is the main reason in

the Indonesia and Kuwait. The impact of oil price is the positive factor on imports, GDP, and price indicators in

any countries. Olomola and Adejumo (2006) examined the effects of oil price shocks on output, inflation, real

exchange rate and money supply in Nigeria using quarterly data from 1970 to 2003. Using VAR methodology

they find that oil price shocks do not have any substantial effect on output and inflation. Oil price shocks only

significantly determine the real exchange rate and in the long run money supply. Olomola and Adejumo conclude

that this may squeeze the tradable sector, giving rise to the "DutchDisease". Study of M. Farzanegan and G.

Markwardt(2007), has entitled, " The Effects of Oil Price Shocks on the Iranian Economy". Due to the high

dependence on oil revenues, oil price fluctuations have a special impact on the Iranian economy. By applying a

VAR approach, this paper analyzes the dynamic relationship between asymmetric oil price shocks and major

macroeconomic variables in Iran. Contrary to previous empirical findings for oil net importing developed

countries, oil price increases (decreases) have a significant positive (negative) impact on industrial output.

Unexpectedly, we can not identify an significant impact of oil price fluctuation on real government expenditures.

The response of real imports and the real effective exchange rate to asymmetric oil price shocks are significant.

Furthermore, the response of inflation to any kind of oil price shocks is significant and positive.

METHODOLOGY

The structural approach to time series uses economic theory to model the relationship among the variables of

interest. Unfortunately, economic theory is often not rich enough to provide a dynamic specification that identifies

all of these relationships. Further more, estimation and inference are complicated by the fact that endogenous

variables may appear on both the left and right sides of equation.

Vector Auto Regression(VARs)

The vector autoregression is commonly used for forecasting system of interrelated time series and for analyzing

the dynamic impact of random disturbances on the system of variables. TheVAR approach sidesteps the need for

structure modeling by treating every endogenous variable in the system as a function of the lagged values of all

the endogenous variables in the system the mathematical representation of varies:

Yt = A1 yt-1 + ….+ Ap yt-p + B xt + ε t

Where Yt is a K vector of endogenous variables, xt is a d vector of exogenous variables, A1,…AP and B are

matrices of coefficients to be estimated, and ε t is a vector of innovations that may be contemporaneously

correlated with all of the right hand sides variables. If economic theory is used to provide the link between

forecast errors and fundamental shocks, we call the resulting model a SVAR. We assume that the economy is

described by a structural from equation:

Β0 yt = k+ β1 yt-1 + β2 yt-2 +…+ βp yt-p + ut

ΒL yt = ut

ΒL = β0 – β1L – β2 L2 -…- βP LP

Page 5

Is a matrix polynomial in the lag operator L, yt Is an k×1 Data vector and ut is an k×1 structural disturbances

vector. A sufficient number of lag of p are included so that ut is vector white noise ut is serially un correlated and

var(ut) = Ω Diagonal matrix where diagonal elements are the variances of structural disturbances . If each side of

(1) is pre-multiplied by β0

Yt = A1 yt-1+ A2 yt-1+…+ Ap yt-p + ε t

Yt = AL yt + ε t

AL = A1 L+ A2 L2 + …+ ApLp

Is a matrix polynomial in lag operator L.

In order to recover the parameters in the structural form equations, Blanchard and Watson (1986) suggest a

generalized method(structural VAR) which allow non-recursive structures and impose restrictions only on

contemporaneous structural parameters.

Then if

Β(L) = β0 + β0(L)

The parameters in the structural form equation and those in the reduce equation are:

A(L) = - β0

In addition, the structural disturbances and the reduce form residuals are related by:

Ut = β0 ε t

Since Σ = E(ε t , ε t), it implies that we can to summarize, it's possible to recover the structural shocks and

variance through the imposition of a sufficient number of restrictions on the β0 matrix defined by equations that

capture the instantaneous correlations among the endogenous variables but the SVAR attempts to identify the

variance decomposition and impulse response functions by imposing a priori restrictions on the covariance matrix

of the structural errors. But the SVAR approach has also some draw backs, one of them is validity of this a prior

restrictions in long run.

In order to overcome this problem we use generalized VAR that was developed by Pesaran an Shin(1998). in this

paper we have also Generalized VAR and SVAR.we use SVAR for short-run and GVAR for long run relationship

between variables.

As a first step we check the properties of the used variables in order to determine the appropriate specification for

VAR estimation. The order of integration for each variable is determined using Augmented Dickey and

Fuller(1979). The results are reported in table 1 in the Appendix B. When all variables are first differenced, we

find evidence that are variable are stationary. Considering that the variables of the model follow a I(1) process, we

analyze in second step whether there is a long relationship among these variables. To test this. We imply Johansen

cointegration tests(see johansen 1991,1995)see table2 in Appendix B. The optimal lag length is 1. The selected

lag length is based on different criteria. Following the results of IRFs and VDC analyses for asymmetric

formations of real oil prices within the Iranian macroeconomy are presented.(see table3 in Appendix B)

Model of Macroeconomics

In this section we briefly describe a simple macroeconomic model for the countries considered in

the study. We consider both long-run and short-run restrictions based on economic theory; while

-1 ,the result is a reduce form equation:

-1 + β0(L)