Abstract
Low and stable inflation is one of the fundamental indicators in evaluating the performance of countries’ economies, as it reflects the stability of a society across all dimensions. Consequently, maintaining inflation at low levels has long been a primary concern of economic policymakers. Achieving this objective requires a comprehensive and precise understanding of the determinants of inflation. This study investigates the factors influencing affecting inflation in Iran, with particular emphasis on the roles of monetary and exchange rate policy instruments. Using quarterly data covering the period 2005–2022, a system of simultaneous equations is specified and estimated. For this purpose, three equations for the general price level, money supply, and the unofficial exchange rate are formulated based on theoretical foundations and the characteristics of the Iranian economy. The estimation results indicate that increases in liquidity and the unofficial exchange rate significantly raise the general price level. Furthermore, the required reserve ratio, as a monetary policy instrument, exerts an inverse effect on liquidity and, consequently, on inflation. Specifically, a decrease (increase) in the required reserve ratio leads to an increase (decrease) in liquidity and, in turn, inflation. Finally, the findings suggest that exchange rate policy decisions aimed at narrowing the gap between official and unofficial rates contribute to further increases in the unofficial exchange rate, thereby intensifying inflationary pressures
Purpose/Aims:
Inflation generates adverse effects across various sectors of society, particularly within the economic sphere. The Iranian economy has experienced persistent double-digit inflation over several decades. The sustained upward trend in inflation during the past decade has underscored the urgency of examining this phenomenon both theoretically and from a policy perspective. A precise identification of the fundamental drivers of inflation is essential, as effective policy design depends on a rigorous understanding of its underlying mechanisms.
A defining feature of inflation in Iran is its close interaction with monetary conditions and exchange rate dynamics. Persistent liquidity growth has been widely recognized as a key determinant of rising price levels. Simultaneously, fluctuations in the exchange rate—especially within the unofficial market—are rapidly transmitted to domestic goods and services prices. Therefore, analyzing inflation requires not only assessing the direct effects of liquidity and exchange rate movements but also examining the mechanisms through which these variables themselves evolve.
Understanding inflation dynamics in Iran necessitates consideration of both the direct impact of liquidity and the unofficial exchange rate on the general price level and the indirect effects of monetary policy on money supply, as well as exchange rate policy in the official market on the unofficial rate. Identifying these transmission channels provides a more comprehensive account of how policy decisions influence inflation. Accordingly, the central research question of this study is: How is inflation in the Iranian economy affected by liquidity, the unofficial exchange rate, and real output, and through which channels do monetary and exchange rate policies exert direct or indirect effects?
Methodology & Framework:
To analyze the determinants of inflation, a system comprising three equations an inflation equation, a money supply equation, and an exchange rate equation is specified.
Inflation equation:

All variables are expressed in logarithmic form. The consumer price index (CPI), representing the general price level, is modeled as a function of money supply (M), real gross domestic product (Y), and the unofficial exchange rate (NE).
Money supply equation:

In this specification, money supply (M) depends on the unofficial exchange rate (NE), nominal gross domestic product (YN), the required reserve ratio (B), and the short-term deposit interest rate (I). All variables are expressed in logarithmic form except for the interest rate.
Exchange rate equation:

The unofficial exchange rate (NE) is modeled as a function of the lagged general price level ( ​), per capita gross domestic product (YPOP)—serving as a proxy for economic and institutional and the official exchange rate (E). All variables are expressed in logarithmic form.
Quarterly data spanning the first quarter of 2005 through the fourth quarter of 2022 were obtained from the Central Bank of Iran. The system comprises 11 variables and 14 parameters. Estimation was conducted using the Two-Stage Least Squares (2SLS) method within a simultaneous equations framework in EViews 13.
Findings:
The estimation results demonstrate that liquidity and the unofficial exchange rate exert significant and quantitatively similar positive effects on inflation. A one percent increase in liquidity raises the general price level by approximately 0.44 percent, while a one percent increase in the unofficial exchange rate increases it by about 0.40 percent.
The money supply equation indicates that the required reserve ratio has a substantial negative effect on liquidity, whereas nominal gross domestic product and the unofficial exchange rate have positive effects. Specifically, a one percent decrease (increase) in the required reserve ratio leads, on average, to a 1.67 percent increase (decrease) in money supply. In contrast, a one percent increase in nominal gross domestic product increases money supply by approximately 0.70 percent, and a one percent increase in the unofficial exchange rate increases it by about 0.30 percent, holding other factors constant.
The unofficial exchange rate equation reveals that institutional factors, proxied by real per capita income exert a significant negative effect (coefficient approximately −1.7). Conversely, lagged inflation and the official exchange rate have positive effects, with coefficients of 0.64 and 0.46, respectively.
A comparison of the estimated equations indicates that monetary and exchange rate policy actions are indirectly transmitted to the general price level. A one percent decrease (increase) in the required reserve ratio increases (decreases) inflation by approximately 0.73 percent through the liquidity channel. Similarly, a one percent increase in the official exchange rate results in an estimated 0.18 percent increase in inflation via the unofficial exchange rate channel.
Discussion:
The findings suggest that inflation dynamics in Iran are shaped by the interaction between monetary conditions and exchange rate movements. Liquidity expansion and fluctuations in the unofficial exchange rate jointly transmit inflationary pressures, indicating that inflation cannot be attributed solely to direct monetary expansion.
Liquidity dynamics are influenced by required reserve ratio, nominal gross domestic product, and the unofficial exchange rate. The required reserve ratio as a monetary policy instrument, affects liquidity and, consequently, inflation, while exchange rate movements and nominal gross domestic product contribute to liquidity expansion through different channels. The results also support the presence of endogenous money supply operating through the exchange rate channel: exchange rate increases raise firms’ costs and household expenditures, stimulate credit demand, and thereby expand money supply endogenously.
Finally, the findings of the study show that changes in the unofficial exchange rate are primarily explained by two main factors: dollarization of the economy, with its underlying causes considered to be institutional factors and high inflation, and official exchange rate policy decisions. Improvements in institutional conditions reduce the unofficial exchange rate and, in turn, inflation. Conversely, increases in lagged inflation and in the official exchange rate lead to higher unofficial exchange rates and, consequently, higher inflation.
Conclusion & Implications:
Based on the results, the study’s policy implications can be summarized as follows. To curb inflation, policymakers can influence inflation by controlling the required reserve ratio and managing the official exchange rate. Moreover, by creating conditions that improve institutional factors, they can strengthen the foundations for inflation stability.
However, given the confirmed endogeneity of money supply through the exchange rate channel, the effectiveness of monetary policy depends critically on prior stabilization of the exchange rate. The results also show that the unofficial exchange rate by increasing firms’ costs and household expenditures, fuels an endogenous rise in liquidity. Therefore, exchange rate stability is essential for effective liquidity management and, consequently, for controlling inflation.