Document Type : Research Paper

Authors

• Sohail Rudari ¹
• Seyyed Hadi Arabi ²
• Sanaz Rahimi Kahkashi ³

¹ Assistant Professor, Department of Islamic Economics, Faculty of Economics and Administrative Sciences, University of Qom, Qom, Iran

² Associate Professor, Department of Islamic Economics, Faculty of Economics and Administrative Sciences, University of Qom, Qom, Iran

³ Ph.D. Candidate, Department of Islamic Economics, Faculty of Economics and Administrative Sciences, University of Qom, Qom, Iran

Abstract

The present study aimed to examine the transfer, reception, and the spillover of volatility from March 1982 to September 2022, using the time-varying parameter vector autoregression model based on Barunik-Krehlik (TV-VAR-BK) with monthly frequency. The results indicated that the primary relationship among the volatility of the analyzed variables is of long-term nature, with the exchange rate emerging as the dominant factor in explaining the volatility of the examined network. In the short term, liquidity serves as the primary transmitter of volatility to inflation and the exchange rate. However, in the medium and long term, the exchange rate becomes the primary transmitter of volatility to inflation, while liquidity acts as the net receiver of currency volatility. Additionally, the long-term impact of the exchange rate is more pronounced. Failure to control currency volatility can lead to inflation turbulence by transferring volatility to liquidity, underscoring the significance of exchange rate stability in managing liquidity and inflation.

Introduction

The exchange rate is one of the key factors influencing inflation. In addressing the impact of exchange rate volatility, the status of inflation plays a crucial role (Tahsili, 2022). Moreover, assessing the factors influencing the exchange rate stands as one of the most challenging empirical problems in macroeconomics (Williamson, 1994). Since the exchange rate is significant economic indicator in any country, alterations in monetary variables (e.g., liquidity and inflation rates) as well as non-monetary variables can lead to fluctuations and instability in the exchange rate (Amrollahi et al., 2021). The causality of volatility between money and inflation can vary depending on economic conditions (Al-Tajaee, 2019). A deeper understanding of liquidity growth dynamics, inflation, and exchange rates in Iran elucidates the reasons behind high inflation, rapid and continuous liquidity growth, and the impact of exchange rate volatility. Extreme changes in each variable overshadow the others, indicating a complex relationship among exchange rates, inflation, and liquidity. Examining the relationship between the volatility of different assets unveils the phenomenon of volatility spillover, where fluctuations in one component trigger volatility in others. An additional crucial aspect is understanding the modes of transmission, reception, and intensity of the causal relationship among exchange rates, inflation, and liquidity in Iran during different periods. In different years, the mutual influence of these components may have varied based on political, economic conditions, health, and pandemic issues, each of which impacting decision-making concerning exchange rates, inflation, and liquidity as three vital macro-economic components. In this respect, the present study used the time-varying parameter vector autoregression model based on Barunik-Krehlik (TV-VAR-BK) with monthly frequency in order to examine volatility spillover from March 1982 to September 2022 in Iran, providing a new perspective on investigating causality by analyzing the time-frequency volatility among exchange rates, inflation, and liquidity.

Materials and Methods

This study is applied and analytical in terms of its purpose and research method, respectively. The data was sourced from the Economic Accounts Department and the National Accounts of the Central Bank. The TVP-VAR-BK model was employed to analyze the time series among exchange rates, inflation, and liquidity. The TVP-VAR-BK model helped analyze the transmission and reception of volatility of variables across different periods (short-term, medium-term, and long-term). Furthermore, the analysis delved into whether the variables acted as net receivers or net transmitters of volatility.

Results and Discussion

The results showed that, in the short term, liquidity exerted the most significant influence and transmitted volatility to other variables. Notably, the most substantial impact and transmission of volatility by the liquidity occurred in 2013, following the tightening of sanctions on Iran. In the medium and long term, the exchange rate emerged as the most influential factor on other research variables.
Examining the causal relationship in the short term, a strong causal connection was identified from liquidity volatility to inflation and the exchange rate. However, no causal relationship was observed between inflation and the exchange rate in the short term. Therefore, in the short term, liquidity could be the primary cause of volatility in inflation and the exchange rate. Failure to control short-term liquidity volatility could lead to severe volatility directly and indirectly within the studied network.
Moving to the medium term, the transfer of volatility was predominantly from the exchange rate to liquidity and, to a lesser extent, from liquidity to inflation. In the medium term, the transfer of volatility from the exchange rate to inflation was less pronounced. This suggests that fluctuations in the exchange rate strongly transfer volatility to liquidity in the medium term, and liquidity significantly contributes to the emergence of inflation volatility. The exchange rate, albeit to a minor extent, can directly contribute to the transfer of volatility to inflation. This underscores the dominant role of the exchange rate in the network during the medium term.
In the long term, no causal relationship between liquidity and inflation was observed, and there was no causality in the transfer of volatility between inflation and the exchange rate. This implies that factors other than the investigated network can explain inflation volatility in the long term. Although there is causality in the transfer of volatility from the exchange rate to liquidity in the short- and medium-term periods, this causality is stronger in the long term. Hence, while the classical view on liquidity and inflation holds until the medium term, the post-Keynesian view becomes evident in the long term. Overall, the exchange rate stands out as the dominant factor in the investigated network. Without stability in the exchange rate, Iran’s economy shall anticipate the fluctuating growth of liquidity and inflation in the short- and medium-term periods.

Conclusion

The primary relationship among the volatility of the examined variables proved to be long-term, with the exchange rate emerging as the dominant factor explaining the volatility within the investigated network. In the short term, liquidity functioned as the net transmitter of volatility to inflation and the exchange rate. However, in the medium and long term, the exchange rate takes on the role of the primary transmitter of volatility, while inflation and liquidity assume the positions of net receivers of currency volatility. Moreover, the impact of the exchange rate was found to be notably stronger. Should exchange rate volatility remain uncontrolled, it has the potential to induce inflation volatility by transferring it to liquidity. This underscores the critical importance of maintaining exchange rate stability for the effective control of liquidity and inflation.

Keywords

• Exchange Rate
• Inflation
• Liquidity
• TVP-VAR-BK Model

Main Subjects

• Macroeconomics