Economic Research and Perspectives

Economic Research and Perspectives

Optimizing Iran’s Monetary and Fiscal Policy under Conditions of Fiscal Dominance

Document Type : Original Article

Authors
Ali Sobhani 1
Ali Taiebnia 2
1 PhD student in Economic Sciences, Monetary Economics, Department of Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran
2 Professor of Economics, Department of Islamic, Institutional and Social Economics, Faculty of Economics, University of Tehran, Tehran, Iran.
10.48311/ecor.2025.24057
Abstract
The high average inflation rate and its volatility—two indicators of macroeconomic instability—have been persistent features of Iran’s economic landscape in recent years. This study identifies fiscal dominance as a principal driver behind the expansion of the monetary base and the rising inflation rate. Evidence from other countries suggests that coordinated fiscal and monetary policies have been instrumental in mitigating fiscal dominance by preventing the transfer of government imbalances to central banks and banking systems. One commonly adopted strategy to curb fiscal deficits has been the issuance of government debt bonds. When bond issuance and yield rates increase, governments tend to restrain deficits and reduce reliance on banking networks. In this study, the impact of bond yield rates, as well as the interest and fees paid by the government for domestic and foreign financing—as recorded in annual budget documents—on fiscal dominance is examined using the Generalized Method of Moments (GMM). The findings reveal that bond yield rates in Iran have not significantly reduced fiscal dominance. However, interest payments and fees associated with domestic and external financing have had a mitigating effect on fiscal dominance.
 
Aim and Introduction:
Persistent inflation and its fluctuations have emerged as defining characteristics of Iran’s economy in recent years, posing serious challenges to macroeconomic stability. This environment of uncertainty has deteriorated the business climate and undermined economic agents’ confidence in future conditions.
According to this study, fiscal domination—defined as the influence of government budgetary operations on monetary policy—is a central factor behind the inflationary trend. In scenarios of fiscal dominance, fiscal policymakers prioritize the monetization of budget deficits, disregarding the constraints imposed by the monetary authority. This is particularly evident in developing countries dependent on crude oil exports. The volatility of oil revenues often results in undisciplined fiscal policies, the effects of which are subsequently transferred to the monetary authority.
To address this issue, some have proposed the establishment of foreign currency reserve accounts aimed at limiting fiscal mismanagement. However, in institutional contexts characterized by unaccountable governments, lack of transparency, and weak adherence to the rule of law, regulatory measures alone have proven insufficient.
Instead, countries that have successfully reduced fiscal dominance have implemented coordinated fiscal and monetary policies. A pivotal strategy among these countries has been the use of government bonds to finance deficits. Whenever bond issuance and yield rates increase, governments become more fiscally disciplined and transfer fewer imbalances to the banking system.
This study investigates the impact of government bond yield rates, along with the interest and fees paid for domestic and foreign borrowing, on the level of fiscal dominance in Iran. The Generalized Method of Moments (GMM) is employed for the analysis. The results suggest that, while bond yield rates have not effectively reduced fiscal dominance in Iran, government payments on domestic and foreign borrowing have contributed to its reduction.
 
Methodology:
Generalized Method of Moments (GMM)
The Generalized Method of Moments (GMM) is an extension of the traditional method of moments, enabling its application to a broader range of models beyond linear regression. The method of moments estimates unknown parameters by equating population moments—functions of these unknown parameters—with corresponding sample moments. GMM is employed due to its several advantages over other econometric techniques.
There are at least four key reasons why GMM is a suitable estimation approach. First, it accommodates the inclusion of endogenous variables. One effective strategy for addressing endogeneity is the use of instrumental variables. Second, GMM facilitates the use of lagged values of variables as valid instruments, providing a practical means of mitigating endogeneity concerns. Third, the method allows for the incorporation of dynamic relationships, enabling the inclusion of lagged dependent variables in the model. Finally, GMM is applicable to time series data, further extending its versatility and utility in empirical research.
 
Findings:
The findings indicate that Iran’s weak institutional framework—characterized by non-compliance with laws, poor legislative quality, ineffective implementation, and lack of government accountability—limits the effectiveness of regulatory reforms aimed at reducing fiscal dominance.
did Rather, market mechanisms such as the yield rate of debt securities should be used. The subject on which the hypothesis of the research is also based.
 
Discussion and Conclusion:
Given the structure of Iran’s economy, in which debt securities represent only a small share of the national budget (during the study period of 2007 to 2019), and considering that the rate of return on these securities is administratively set, it can be concluded that—at present—this rate does not significantly contribute to reducing fiscal dominance or narrowing budget deficits in Iran’s economy. However, it is expected that, in the future, following current trends, this mechanism may enhance fiscal discipline and help mitigate fiscal dominance.
The primary reason lies in the fundamental differences between developed and developing economies. Developed economies typically possess large, international capital markets with floating interest rates and the capacity to issue debt securities across a range of maturities. In contrast, developing countries such as Iran lack such dynamic capital markets, limiting their ability to finance budget deficits through non-monetary means. As a result, these countries often resort to borrowing from the banking system. This borrowing ceiling makes the expansion of the monetary base—and hence the money supply—a necessary policy tool for covering budget deficits, thereby intensifying fiscal dominance.
Unlike debt securities, which have thus far failed to reduce fiscal dominance in Iran’s economy, the estimated effects in this study suggest that the interest payments on domestic facilities and foreign financing, as recorded in the budget, have had a more meaningful impact. These obligations are formally recognized by the government as debt and are accompanied by designated revenue sources for their repayment. This acknowledgment contributes to reducing fiscal dominance.
This finding is of particular importance: it underscores that the proper documentation of government debt in the national budget—and the legal obligation for repayment—is critical for improving fiscal performance. One of the fundamental challenges currently facing Iran’s economy is the absence of a comprehensive and transparent accounting of government debt. A substantial portion of government liabilities to the banking system is not recorded in the official budget, and the government assumes no formal responsibility for their repayment. This practice has normalized fiscal dependence on the monetary authority across successive administrations and continues to fuel the structural drivers of liquidity creation in Iran’s economy.
Keywords
Fiscal Dominance, Fiscal Policy, Inflation Rate, Monetary Policy

Subjects

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