The Impact of Shocks in Oil price and Exchange Rate on Inflation in Iran: The Application of the VAR Approach

Abstract

Iran is one of the oil exporting countries, so the oil price plays a remarkable role in the government budget and is a major source of foreign exchange. On the other hand, the reliance of the government budget to oil income as well as its fluctuations is a fact referred to as the most important cause of inflation by many researchers. This paper explores the effect of shocks in the exchange rate, oil price, and production as the three main shocks in the economy on the most important variable in Iran's macroeconomy, i.e. price level. So, the vector auto-regression (VAR) model is used with seasonal data for the period of 1991-2016. After the model is estimated, impulse response functions are calculated and analysis of variance is performed to figure out the contribution of each shock in the variance of the prediction error of these variables. The results show that the strong dependence of exchange rate on foreign exchange earnings of oil price allows the rapid growth of the prices in Iran and the effect of the shock is increasing over time. Also, sanctions in 2012 did not reduce oil price, but they influenced the exchange rate and inflation significantly.