This paper investigates the behavioral function of money supply in the Iranian economy, focusing on the interaction between monetary policymaking and various macroeconomic variables that influence liquidity, particularly the role of exchange rate fluctuations in endogenously shaping liquidity dynamics. To this end, the Autoregressive Distributed Lag (ARDL) and Fully Modified Ordinary Least Squares (FMOLS) methods are applied using quarterly data from Spring 2005 to Winter 2023. The findings indicate that both the exchange rate and gross domestic product (GDP) exert direct and statistically significant effects on liquidity. Specifically, an increase in the exchange rate endogenously elevates liquidity, while the impact of GDP likely reflects either the money supply’s response to real sector expansion or proactive monetary policies aimed at stimulating production. Additionally, the legal reserve ratio is found to have a negative and statistically significant effect on liquidity, consistent with its constraining influence on bank lending capacity. These results underscore the legal reserve ratio as the most effective policy instrument available to Iranian monetary authorities for managing liquidity. Given that the money multiplier has been approximately eight in recent years—and that most liquidity originates as inside money created by commercial banks—successful monetary policy in Iran necessitates attention to exchange rate volatility, reaffirming the validity of the endogenous money hypothesis in the Iranian context.

Aim and Introduction

If a connection between the volume of circulating liquidity and the general price level under specific conditions is accepted, then understanding the nature of liquidity becomes crucial for effective policymaking. Changes in liquidity can arise externally through central bank interventions (outside money) or internally through the operations of commercial banks (inside money). In economies where liquidity changes are primarily driven by external factors, direct control over the monetary base is the primary policy tool. Conversely, when internal mechanisms dominate, adjusting the legal reserve requirement becomes a more effective lever.

However, the feasibility of liquidity management by monetary authorities hinges on the assumption that money is exogenous—that is, the money supply can be adjusted independently by policymakers to meet macroeconomic objectives such as low inflation and sustained growth. In conventional monetary theory, the money supply is treated as exogenous in macroeconomic modeling, implying that changes in the money supply drive movements in nominal and real economic variables.

Contrastingly, Post-Keynesian theory asserts that money is endogenous and that monetary authorities are largely passive in responding to changes in money demand. This perspective argues that increases in credit demand—primarily driven by rising production costs, particularly wages—lead to corresponding increases in the money supply. The emphasis on wage costs arises because Post-Keynesian analyses typically focus on advanced economies, where strong labor unions elevate wages above market-clearing levels and where the availability of capital goods and raw materials is less constrained than in developing countries.

In contrast, one of the defining features of Iran’s production and consumption structure is its dependence on imports. This dependency causes exchange rate fluctuations to influence the money supply endogenously, through increased money demand arising from two primary channels: higher production costs for firms and increased expenditures by consumers, both public and private. Over 80% of Iran’s imports consist of raw materials and intermediate or capital goods. Thus, an exchange rate hike increases production costs for firms reliant on imported inputs, prompting greater demand for working capital and, consequently, credit from the banking system. Similarly, higher exchange rates elevate consumer prices via both direct (imported goods) and indirect (inflation) effects, further increasing credit demand and resulting in endogenous growth in the money supply.

The implications of the Post-Keynesian view are profound for both macroeconomic theory and policy (Niggel, 1991). Theoretically, it challenges the validity of neoclassical, neoclassical synthesis, and traditional monetarist models that assume an independent money supply. From a policy perspective, it questions the effectiveness of central bank interventions aimed at controlling credit and money growth. This study, therefore, explores a behavioral function of money supply to analyze both the variables under the direct influence of policymakers and those that endogenously shape monetary dynamics via cost-push mechanisms.

Methodology

To examine the role of exchange rate dynamics in shaping money supply behavior in Iran, the following log-linear behavioral equation is specified based on theoretical foundations and empirical literature:

Ln M = f(Ln E, Ln Y, Ln b, i )

Where:

Ln M denotes the natural logarithm of liquidity (money supply),

Ln E is the natural logarithm of the unofficial exchange rate,

Ln Y represents the natural logarithm of Gross Domestic Product (GDP),

Ln b is the natural logarithm of the legal reserve ratio, and

i is the short-term deposit interest rate.

The model is estimated using quarterly data from Spring 2005 to Winter 2022 via two econometric techniques: the Autoregressive Distributed Lag (ARDL) model and the Fully Modified Ordinary Least Squares (FMOLS) approach. All estimations are conducted using EViews 13.

Results and Discussion

The estimation results confirm that both the exchange rate and GDP have a direct and statistically significant relationship with money supply, with coefficients significant at the 95% confidence level or higher. The exchange rate positively affects money supply endogenously, reflecting heightened credit demand resulting from increased costs for firms and consumers. GDP exerts an even more substantial influence, potentially due to the monetary system's response to real sector expansion or active monetary policies designed to stimulate production.

Moreover, the legal reserve ratio has a negative and statistically significant impact on money supply, also at the 95% confidence level. An increase in the reserve requirement reduces the banking system’s capacity to extend credit, thereby slowing liquidity growth. These results align with theoretical expectations and highlight the critical role of reserve requirements in managing credit creation.

Conclusion

This study employs a behavioral model of money supply to analyze the impact of key variables on liquidity in the Iranian economy. It finds that exchange rate fluctuations endogenously increase the money supply, while the impact of GDP likely reflects either the money supply’s response to real sector expansion or proactive monetary policies aimed at stimulating production. At the same time, the legal reserve ratio serves as an effective policy tool for monetary control. These findings corroborate the Post-Keynesian view that money in Iran is endogenously determined—primarily through credit mechanisms within commercial banks.

Given that the Central Bank’s time series data show a money multiplier of approximately eight in recent years and that the majority of liquidity is internally generated, the most viable instrument for monetary policy remains the legal reserve ratio. Nonetheless, effective liquidity management also requires stabilizing exchange rate movements, underscoring the limitations of relying solely on traditional tools in an economy where money supply is largely endogenous.