Economic Research and Perspectives

Economic Research and Perspectives

Time-Varying Connectedness across Exchange Rate, Inflation, Budget Deficit, and Liquidity in Iran A TVP-TVAR Approach

Authors
Soheil Roudari 1
Hamidreza Maghsoudi 2
Farzaneh Ahmadian-Yazdi 3
1 Department of economics, Faculty of economics and administrative sciences, Ferdowsi University of Mashhad, Mashhad, Iran
2 Assistant professor, Islamic economics department, Faculty of economics and administrative sciences, Qom University, Qom, Iran
3 Assistant professor, Department of economics, Faculty of economics and administrative sciences, Ferdowsi University of Mashhad, Mashhad, Iran
10.48311/ecor.2025.13659
Abstract
This study investigates the dynamic interrelationships among key macroeconomic variables in Iran—namely the exchange rate, inflation, government budget deficit, and liquidity—using the Time-Varying Parameter Threshold Vector Autoregression method, based on monthly data from March 2006 to August 2023. The findings reveal a complex and time-varying structure of connectedness among these variables, influenced significantly by political and external shocks such as sanctions. The results indicate that the exchange rate and liquidity act as the main net transmitters of volatility, while inflation and the budget deficit are primarily net receivers. The TCI averages around 23%, with over 70% of the interdependence attributed to external and non-economic factors. Threshold analysis shows that when the growth rate of macroeconomic variables remains below 24% annually (2% monthly), the exchange rate strongly affects inflation, while no significant interaction is observed among the other variables. In contrast, during negative growth rates (up to -3% monthly), the exchange rate has a dominant effect on both inflation and, to a lesser extent, the budget deficit and liquidity. Moreover, periods of intensified sanctions (2012–2016, 2018–2019) coincide with increased connectedness, largely due to inflationary expectations, reduced foreign currency supply, and expansionary fiscal policies such as debt issuance. These findings underscore the pivotal role of the exchange rate in Iran’s macroeconomic network. For effective macroeconomic management, it is crucial to implement a managed floating exchange rate regime and maintain macro variable growth below critical thresholds. Otherwise, political economy dynamics and expectations may override monetary and fiscal policy effectiveness

Aim and Introduction

One of the most important issues in Iran's economy is related to managing the exchange rate, inflation and budget deficit. During tightening of the sanctions, the oil revenues are limited which potentially leads to an increase in the budget deficit as well as a decrease in the currency supply which accelerates the exchange rate. On the other hand, with the increase in the budget deficit, the probability of borrowing from the banking system and also the issuance of bonds increases, which in turn rise the monetary base and liquidity. In addition, inflationary expectations also increase, which can be effective in improving assets prices. With an increase in inflation, based on the inflation-currency spiral, there is a possibility of a grow in exchange rate in order to maintain the competitiveness of domestic production. This can accelerate the price of imported commodities and cause domestic inflation again. With the increase in inflation and households spending, nominal wages will have a higher growth compared to normal conditions in order to maintain minimum purchasing power, which can again face the government with limited resources and more borrowing to meet current expenses. From the monetarists’ point of view and the classical economics, in general, the main stimulator in increasing inflation is the growth of money and liquidity. However, from the post-Keynesian economists’ point of view, inflation increases the demand of money and subsequently liquidity. On the other hand, with an increase in the exchange rate, the government's expenses usually increase more than its income, which can lead to an increase in the government's budget deficit. Also, considering the existence of a monopoly in currency supply by the central bank, the hypothesis of using currency exchange revenues (the difference between free and budget-approved currency) will be applicable and this issue can raise the impact of the budget deficit on the exchange rate. Therefore, there has always been a serious challenge among economists as well as macroeconomic decision-makers about the connectedness between macroeconomic variables. What is the main driver of the network between macro variables? Is there a different way of communication in different thresholds of their growth rate? These cases show that it is very important to examine the time-varying interrelationships between these macroeconomic variables.

Accordingly, there is a complex connection between exchange rate, inflation, budget deficit and liquidity, which can be varied in different years. Therefore, in this research, using the TVP-TVAR technique, the time-varying connectedness across exchange rate, inflation, budget deficit and liquidity is examined during March, 2006 to August, 2023.

Methodology

In the current research, the relationship between exchange rate fluctuations, inflation, government budget deficit and liquidity based on monthly data using the TVP-TVAR technique is investigated. It should be noted that all the required information is extracted from the economic indicators of the central bank, and the government's budget deficit data from 2017 onward are extracted from Iran's Program and Budget Organization.

Findings

The results show that exchange rate and liquidity are, respectively, the largest net transmitter of volatilities in the network. Moreover, inflation rate and government budget deficit, respectively, are the largest net receivers of shocks from network. On average, the TCI is 23%, and more than 70% of this interrelationship between variables is explained by other factors such as political ones. Moreover, if the variables underestimated grow up to 36% annually (3% monthly), the connection between them will be cut off. In the conditions of decreasing the growth rate of variables up to -3% per month, the exchange rate has played a dominant role and its volatilities are transferred more strongly to inflation rate and less strongly to the budget deficit and liquidity.

If the growth rate of the variables is up to 24% annually (threshold of +2% monthly growth rate), the exchange rate volatilities are transferred to inflation and no interconnectedness between other variables is observed.

Discussion and Conclusion

Our results show that, on average, the total connectedness index from 2012 to 2016 has been upward, which is caused by the tightening of sanctions and the increase in inflationary expectations, psychological factors and emotions. Moreover, the connectedness between them is increased in 2018 and 2019, which is related to the intensification of sanctions and the reduction of currency supply and the increase in inflation and budget deficit and subsequently the increase in the issuance of debt securities in the capital market in order to manage the budget deficit and as a result increase liquidity. The results show that exchange rate is a main net transmitter of volatilities in most years and the inflation rate is a main net receiver of volatilities in many years. From 2016 onwards, the budget deficit is the net receiver of shocks from network in most periods, except for one period in 2019. It is interesting to note that in 2019, with the increase in the budget deficit and the issuance of debt securities, the budget deficit is transmitter, liquidity is receiver and inflation is more receiver variable than liquidity in the network. Totally, the results show that exchange rate is the major net transmitter of shocks to other macro variables.

Moreover, based on the results of the sensitivity analysis and thresholds effect, if the growth rate of variables is up to 24% annually (threshold of +2% monthly growth rate), the exchange rate fluctuations will be transferred to inflation and no connection between other components is observed. This shows that the macroeconomic management of the economy is very sensitive to the growth rate of the thresholds of the macroeconomic components, and before the political economy and also the factors of expectations and emotions dominated the economy, the macroeconomic management, especially the exchange rate, is required. Otherwise, it is impossible to manage the investigated variables with monetary and fiscal policies. Therefore, the managed floating exchange rate should be taken into consideration and if the goal is to manage the network using macroeconomic theories, the variables should not be allowed to increase by more than 24% annual growth. Other factors such as the political economy, and especially inflationary expectations will get the dominant role in the economy
Keywords
Budget deficit
Exchange rate
Inflation rate
Liquidity
TVP-TVAR Model

Subjects

Abu, N., & Abd Karim, M. Z. (2015). The non-linear relationship between fiscal deficits and inflation: evidence from Africa. South East European Journal of Economics and Business, 10(2), 102-112.
Afonso, A., & Opoku, P. K. (2022). The nexus between fiscal and current account imbalances in OECD economies. Applied Economics, 1-18.
Afonso, A., Huart, F., Jalles, J. T., & Stanek, P. (2022). Twin Deficits Revisited: a role for fiscal institutions?. Journal of International Money and Finance, 121, 102506.
Agu, P. C., & Oshim, J. C. (2024). Effect 0f Deficit Budget Financing Sources on Inflation Rate in Nigeria. International Journal of Business and Management Review, 12(1), 116-131.
Ahmad, A. H., & Aworinde, O. B. (2019). Are fiscal deficits inflationary in African countries? New evidence from an asymmetric cointegration analysis. The North American Journal of Economics and Finance, 50, 100999.
Asadi, M., Roubaud, D., & Tiwari, A. K. (2022). Volatility spillovers amid crude oil, natural gas, coal, stock, and currency markets in the US and China based on time and frequency domain connectedness. Energy Economics, 109, 105961.
Asl, M. G., Bouri, E., Darehshiri, S., & Gabauer, D. (2021). Good and bad volatility spillovers in the cryptocurrency market: New Evidence from a TVP-VAR asymmetric connectedness approach. Available at SSRN 3957317.
Bahmani-Oskooee, M., & Gelan, A. (2018). Exchange-rate volatility and international trade performance: Evidence from 12 African countries. Economic Analysis and Policy, 58, 14-21.
Balcilar, M., Gabauer, D., & Umar, Z. (2021). Crude Oil futures contracts and commodity markets: New evidence from a TVP-VAR extended joint connectedness approach. Resources Policy, 73, 102219.
Baradaran Khanian, Z., Asgharpur, H., Panahi, H. & Kazerooni, A. (2017). The Asymmetric Effect of Inflation on the Budget Deficit in Iran: Quantile Regression Approach, Quarterly Journal of Applied Theories of Economics, 4, 169-194. (In Persian)
Barro, R. J. (1979). On the determination of the public debt. Journal of political Economy, 87(5, Part 1), 940-971.
Bilman, M. E., & Karaoğlan, S. (2020). Does the twin deficit hypothesis hold in the OECD countries under different real interest rate regimes?. Journal of Policy Modeling, 42(1), 205-215.
Bulawayo, M., Chibwe, F., & Seshamani, V. (2018). The impact of budget deficits on inflation in Zambia. Journal of Economics and Development Studies, 6(2), 13-23.
Ferrara, L., Metelli, L., Natoli, F., & Siena, D. (2021). Questioning the puzzle: fiscal policy, real exchange rate and inflation. Journal of International Economics, 133, 103524.
Ganchev, G. T. (2010). The twin deficit hypothesis: the case of Bulgaria. Financial theory and Practice, 34(4), 357-377.
Gong, X., Xu, J., Zhou, Z., & Liu, T. (2022). Dynamic volatility connectedness between industrial metal markets. The North American Journal of Economics and Finance, 101814.
Hashemi F, Hosseini S, Hozhabr Kiani K, Farzin M R. (2023). Investigating the Relationship between Inflation and Exchange Rate Jumps by Considering the Index of the Central Bank's Intervention Degree and Using the Dornbush launch Model. Quarterly Journal of Economic Research and Policy, 31 (107), 7-42. (In Persian)
Helmy, H. E. (2018). The twin deficit hypothesis in Egypt. Journal of Policy Modeling, 40(2), 328-349.
Hosseinipour, S.M.R. (2017). Causality Assessment among Budget Deficit, Money Supply and Inflation Rate in Iran, The Quarterly Journal of the Macro and Strategic Policies, 6, 80-100. (In Persian)
Istiqomah, N., & Mafruhah, I. (2022). The Effect of Budget Deficit in Indonesia: A Comparative Study. Economics Development Analysis Journal, 11(1), 110-119.
Jalil, A., Tariq, R., & Bibi, N. (2014). Fiscal deficit and inflation: new evidences from Pakistan using a bound testing approach. Economic Modelling, 37, 120-126.
Karras, G. (2019). Are “twin deficits” asymmetric? Evidence on government budget and current account balances, 1870–2013. International Economics, 158, 12-24.
Kazemzade, A., Karimi Potanlar, S. & Jafari Samimi, A. (2020). An Analysis of the Terence Effect and the Anti-Tensile Effect in Iran's Economy: Discrete Wavelet Transform Method and a Threshold Vector Autoregressive Model, Macroeconomics Research Letter, 15, 13-37.doi: 10.22080/IEJM.2020.16858.1701. (In Persian)
Koop, G., Pesaran, M. H., and Potter, S. M. (1996). Impulse response analysis in nonlinear multivariate models. Journal of Econometrics, 74(1), 119–147.
Mehmood, K., Ahmad, S., Mehmood, T., Mohsin, M., & Ishfaq, M. (2022). Does Laffer Curve Exist in Tax Structure of Pakistan? A Threshold Regression Analysis. Journal of Economic Impact, 4(1), 145-149.
Mehrara, M., Gholami, A. & Ahmadi, S.M.M. (2023). The dynamic and pivotal role of private sector savings in proving the evidence of the triple deficit in Iran, The Journal of Economic Studies and Policies, 9, 203-226. (In Persian)
Miller, P. J. (1983). Higher deficit policies lead to higher inflation. Quarterly Review, 7(Win).
Montazeri Shoorekchali, J., zahed gharavi, M. & Ehsani, M. (2021). Inflation and budget deficit in Iranian economy: Granger causality approach Markov switching, Applied Economics, 11, 53-69. (In Persian)
Myovella, G. A., & Kisava, Z. S. (2018). Budget deficit and inflation in Tanzania: ARDL bound test approach. Journal of Business Economics and Finance, 7(1), 83-88.
Naeem, M. A., Chatziantoniou, I., Gabauer, D., & Karim, S. (2024). Measuring the G20 stock market return transmission mechanism: Evidence from the R2 connectedness approach. International Review of Financial Analysis, 91, 102986.
Nasirpour, A., Sharifi-Renani, H., Daei Karimzadeh, S. & Basirat M. (2019). An Analysis of the Effects of Monetary and Fiscal Policies on the Current Account Deficit in Selected Oil Exporting Countries: A P-VAR Approach. The Journal of Planning and Budgeting. 24, 81-112. doi:10.29252/jpbud.24.2.81 (In Persian)
Nham, N., T. H. (2022). An application of a TVP-VAR extended joint connected approach to explore connectedness between WTI crude oil, gold, stock, and cryptocurrencies during the COVID-19 health crisis. Technological Forecasting and Social Change, 83, 121909.
Olalekan Olaniyi, C. (2020). Application of bootstrap simulation and asymmetric causal approach to fiscal deficit-inflation nexus. Global Journal of Emerging Market Economies, 12(2), 123-140.
Omodi, V., Gudarzi farahani, Y. & Roudari, S. (2023). Investigating the quantile time-varying relationship between exchange rate, current account deficit, government budget deficit, and inflation in the Iranian economy, Journal of Econometric Modelling, 8, 129-157. Doi: 10.22075/JEM.2023.29051.1783. (In Persian)
Patinkin, D. (1969). The Chicago tradition, the quantity theory, and Friedman. Journal of Money, Credit and Banking, 1(1), 46-70.
Pesaran, H. H. and Shin, Y. (1998). Generalized impulse response analysis in linear multivariate models. Economics Letters, 58(1), 17–29.
Rajakaruna, I., & Suardi, S. (2021). The dynamic linkages between current account deficit and budget balance deficit in the South Asian region. Journal of Asian Economics, 77, 101393.
Saboori Deylami, M.H., Elahi, N., Kiaalhoseini, S.Z.A. & Yousefi sheikh robaat, M.R. (2021). Existence of Exchange Rate-Inflation Vicious Circle Hypothesis in Iran: A MSBVAR Approach, The Journal of Economic Studies and Policies, 8, 7-30. Doi: 10.22096/esp.2019.37179. (In Persian)
Şahin, B. E. (2019). Analysis of the relationship between inflation, budget deficit and money supply in Turkey by ARDL approach: 1980-2017. Journal of Life Economics, 6(3), 297-306.
Sargent, T. J., & Wallace, N. (1981). Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis quarterly review, 5(3), 1-17.
Shakeri, A., & Bagherpour Oskouie, E. (2023). Nature of the Inflation in Iranian Economy: Wavelet Coherence Approach. Iranian Journal of Economic Research, 28(94), 47-79. doi: 10.22054/ijer.2022.63350.1036
Suleiman Sa’ad, A. A., & Michael, O. B. A. (2018). An econometric analysis of the nexus of exchange rate, inflation and budget deficit: Case of Nigeria 1981–2016. Journal of World Economic Research, 7(1), 1-13.
Ur Rehman, F., Ahmed, K. A., & Ali, S. (2008). The impact of budget deficit on inflation in Pakistan:(1970-2004). European Journal of Scientific Research, 20(3), 715-720.
Zaroki, S., Yousefi barfurushi, A. & Moghadasi Sedehi, A. (2020). Testing the Effect of Tanzi and Patinkin in Iran’s Economy, Economic Research, 55, 347-372. Doi: 10.22059/JTE.2020.291751.1008256. (In Persian)