Document Type : Research Paper

Authors

• Reza Alaei ¹
• Ahmad Salahmanesh ²

¹ Assistant Professor of Economics, Shahid Chmaran University of Ahvaz, Ahvaz, Iran

² Associate Professor of Economics, Shahid Chamran University of Ahvaz, Ahvaz, Iran

Abstract

Abstract
The present study examined the effect of uncertainty on specific monetary policy transmission mechanisms in Iran from the first quarter of 1990 to the fourth quarter of 2022. First, the three variables representing the Central Bank’s policy instruments were considered, namely monetary base (BM), money (M₁), and liquidity (M₂), along with two target variables of GDP and inflation. The VAR-X method was used to analyze the three monetary transmission channels: Interest rate, exchange rate, and credits. The findings indicated the central role of the credit channel, regardless of the Central Bank’s policy variable or target. However, the effectiveness of the interest rate and exchange rate channels varies depending on the type of policy instrument and the target variable. The study also explored the effect of different levels of uncertainty on the monetary transmission channels. The 90th and 10th percentiles of the optimal economic uncertainty index were used as proxies for high and low uncertainty, respectively. The analysis employed the interaction vector autoregression (IVAR) method and extracted impulse response functions (IRFs) for GDP and inflation. According to the results, monetary policy transmission functions operated differently under varying levels of uncertainty, indicating that the level of uncertainty significantly affects the monetary policy transmission channels.

Introduction

An examination of changes in Iran’s economy over the past few decades shows that it has faced multiple challenges, including chronic recessions, inflation, exchange rate fluctuations, economic reform plans, and severe international sanctions. These factors have contributed to heightened economic uncertainty. Meanwhile, monetary policies have been widely applied in Iran to stabilize the economy and achieve policymakers’ objectives, despite the theoretical and empirical evidence emphasizing the impact of uncertainty on monetary policy effectiveness. Concerning the literature on monetary policy transmission mechanisms in Iran, while some research has identified various transmission channels, no studies have specifically examined the performance of these channels under different uncertainty conditions. Understanding the transmission channels of monetary policy and the impact of uncertainty on them can help policymakers control the monetary policy and make its outcomes more predictable across varying economic conditions. In this respect, the current study aimed to analyze the three primary channels of monetary policy transmission: Interest rate, exchange rate, and credit. Then, it applied the optimal economic uncertainty index developed by Alaei et al. (2018) to evaluate the uncertainty effect on the transmission channels.

Materials and Methods

This study followed a three-step process. First, an uncertainty index was created by updating the optimal economic uncertainty index for Iran’s economy, originally developed by Alaei et al. (2018). Second, the two-stage approach used in studies by Poddar et al. (2006), Nyumuah (2018), and Anwar and Nguyen (2018) was applied—along with the extraction of impulse response functions (IRFs) from VAR and VAR-X models—to examine the monetary transmission mechanisms. Finally, the interactive vector autoregression (IVAR) method was employed to assess the effect of uncertainty on the monetary transmission mechanisms.

Results and Discussion

The analysis focused on the three policy instruments adopted by the Central Bank: The growth rate of monetary base, money growth, and liquidity. It thus examined the three monetary transmission channels: interest rate, exchange rate, and credit. These channels were analyzed in relation to two target variables, inflation (LCPI) and production (LGDP). The results indicate that the effectiveness of each transmission channel varies depending on the type of policy instrument used and the specific target variable, as shown in Table 1.
Table 1. Results of Examination of Monetary Transmission Channels




Instrument


Target


Confirmed Monetary Transmission Channels




 
Logarithm of Monetary Base (LBM)


Logarithm of Production (LGDP)


Credit




Logarithm of Consumer Price Index (LCPI)


Real Exchange Rate, Credit




 
Logarithm of Money ( )


Logarithm of Production (LGDP)


Real Exchange Rate, Credit




Logarithm of Consumer Price Index (LCPI)


Interest Rate, Credit




 
Logarithm of Liquidity ( )


Logarithm of Production (LGDP)


Interest Rate, Credit




Logarithm of Consumer Price Index (LCPI)


Real Exchange Rate, Credit




 Source: Research results
The investigation into the effect of uncertainty on monetary transmission channels reveals that it varies depending on the type of policy instrument and the Central Bank’s target variable. During the period under study, when the logarithm of the monetary base (LBM) was used as a policy instrument with the growth rate of the logarithm of the consumer price index (LCPI) as the target variable, high levels of uncertainty would weaken both the exchange rate and credit channels. This results in less effective transmission of shocks from the LBM variable to the LCPI target, as uncertainty reduces the power of these monetary transmission channels. However, when the production variable (LGDP) served as the target, high uncertainty instead strengthened the credit channel. In this case, LGDP exhibited a heightened response to shocks on the LBM variable. Considering the logarithm of money (LM₁) as the policy instrument, the analysis of the interest rate channel indicated that lower uncertainty strengthened this channel in transmitting shocks on LM₁ toward the LCPI target. In contrast, differing levels of uncertainty did not significantly impact the effectiveness of the exchange rate channel in transmitting LM₁ shocks to LGDP. For the credit channel, high uncertainty caused LGDP to respond more slowly to shocks, while uncertainty did not appear to affect the credit channel’s influence on the response of LCPI to LM₁ shocks. Considering the logarithm of liquidity (LM₂) as the policy instrument, not only did uncertainty lead to a change of the interest rate channel to LGDP, but also the response of the target variable at high uncertainty levels increased. Similarly, high uncertainty strengthened the exchange rate channel, resulting in an increased LCPI response to shocks on LM₂. An analysis of the credit channel under high uncertainty revealed a stronger LGDP response to shocks in the 4th period; however, this response weakened over time. In contrast, with LCPI as the target, lower levels of uncertainty strengthened the credit channel, leading to a greater response of the target variable to shocks.

Conclusion

The findings revealed that the credit channel remained valid regardless of the Central Bank’s policy instrument or target variable. However, the validity of other channels was sensitive to changes in the policy instrument or the target variable. Concerning the period under study, the monetary transmission channels operated differently across different levels of uncertainty. In fact, the impact of uncertainty on the monetary transmission channels proved to be significant, though its influence varied in degree across channels.

Keywords

• Optimal Economic Uncertainty Index
• Monetary Policy Transmission Mechanism
• VAR-X Model
• IVAR Model

Main Subjects

• Monetary economy