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TRANSCRIPT
The Role Of Central Bank and Monetary
Policy In Iran
By
Saeed Abtahi
UCLA October 13, 2013
Copyright © Andishgah.Org 2013. All Rights Reserved. 1
Introduction
Iran’s Economy
Central Bank
Monetary Policy
Central Bank Governance
Recommendation for Bank Markazi’s
Inflation and Monetary Policy In Iran
What are the Causes Of Chronic Inflation In Iran
A Framework For Analyzing Iran’s Financial Health
Is There a Hope?
2
Content
Society and Economy
An economic system consist of the production, distribution,
trade and consumption of limited goods and services by
different agents in a given geographical location.
3
A human society, is a group of people involved with each other
through various relations.
Man’s Requirements
Economic
Political Social
Transformation of a Society Requires An Acknowledgement of Man's
Requirement In Three Inter-related Spheres of Activities: Economic, Political,
and Social.
Economic development is more than a rise of GNP. Material advancement should
expand people's entitlements, self-esteem, capabilities, and freedom.
4
An Economy Is A Complex Organization
Economies are not:
Simple
Static
Linear
Predictable
Economies are:
Complex
Dynamic
Non-linear
Stochastic
Understanding economic issues will be enhanced by
employing a multi-disciplinary approach that combines:
Psychology
Sociology
Anthropology
History
Lately, neuroscience
Economics is not a science, but can draw analogies from it.
5
Populist View of the Economic Issues is Destructive
The previous administration, effectively, saw economic
relationship as:
Compartmentalized (no feedback)
Linear
Non-stochastic
Known lag
To ignore the progress made in the field of economics
since the late 17th century and instead view the world
deterministically is a recipe for disaster.
C
B
A
Time
Output
Today Future
D
6
An Ideological View of Economy
Effective policymaking first and
foremost requires:
Gathering data;
Building models; and
Applying reason, and
rationalism.
Economic Models
Economic models are subjective approximations of reality designed to explain
observed phenomena.
The very process of constructing, testing, and revising models forces
policymakers to crystallize their views about how an economy works.
This in turn promotes rational and constructive debates over what drives economic
behavior and what should (or should not) be done to address market issues.
7
8
Problems With Data and Models in Iran
Iran's Center of the Statistics in August 2013 announced the growth rate for Iran in
1391 (2011) was negative 5.4%. The same organization just before the end of Mr.
Ahmadinejad's term announced a growth rate of just negative 1%. Why the
discrepancy?
In August 2010, Iran's Central Bank had not stated the country's official economic
growth rate for the previous two years. It was claimed that, "the bank knows that
Iran's economic growth rate was around 0.5% in 2008 but it has been under
government pressure not to publish it as it is in contradiction with Ahmadinejad's
words in this regard." Why the delay?
Inaccurate
Data
Inaccurate
Models
Wrong
Execution + = Crisis
The Pillars of Economy
Players
(Households, Firms, Governments)
Economic
Variables
Infrastructure
Judiciary System
Judicial independence
Impartial courts
Protection of property rights
Integrity of legal system
Enforcement of contract
Reliability of police
9
Role of Institutions In Economies
There is no unique set of institutions that fit every country. But there are four that are common to
developing countries:
Market-Creating Institutions: Property rights and legally binding contracts.
Market-Regulating Institutions: Regulatory institutions.
Market-Stabilizing Institutions: Institutions for macroeconomic stability.
Market-Legitimizing Institutions: Institutions for conflict management.
10
Source: A.P. Thirlwall "Economic Development " Chapter 4.
Role of Institutions – cont.
These Institutions:
Enforce property rights and the rule of law.
Provides individuals with the incentive to save, invest, and take risks.
Prevent those in power to expropriate the resources for their own benefit.
Provide equal opportunity for all.
11
Source: D. Acemoglu "Root Causes: An Historical Approach to Assessing the
Role of Institutions in Economic Development."
Trust and Institutions
Trust in
Business
Leaders
Technology
Trust in
Judiciary
System
Trust in
Financial
System
Trust in
Media
Trust in
Bankers
Trust in
Politicians
Economic Development Requires
Trust at Every Level.
Trust Must Operates at Many Levels
12
Iran's Economy
13
A Highly Centralized Society in Iran
Government Intervenes
Central Government
State and Local Governments
State-Run Enterprises
State-Supported Charities
Government Intervenes
Prices and Wages
Dividends
Rates of Return
Exchange Rates
Business
Government Intervenes
What to wear
What to drink
What to publish
What to write
How to socialize
Government
Controls 85% of
Iran's Economy
Government employees increased
by 4x while population doubled
since the 1979 revolution.
Government budget during 2000-
2010 catapulted by a factor of
10x.
The role of government is not to take the place of the marketplace, but to improve the
functioning of the market economy.
(Political) (Economic)
(Social)
M. Renani "Iran's Three Crisis" in www.ireconomy.ir
August 12, 2013 14
Misguided Economic Policies
Loans for
quick-return
projects
Subsidized
residential
loans
Targeted
subsidies
Misguided fiscal and monetary policies
Controlling credit (rate, amount, and target)
Funding populist projects
Supporting over-valued currency
+
Stagflation
15
Disregard In Basic Economic Laws
From Oil Revenue to Stagflation
Government Bank
Markazi
Various Economic
Units
Banking System
(Reserves) x Money
Multiplier = Increases
Liquidity
Inflation Higher
Imports
Domestic Manufacturers
Are Hurt Unemployment
$
Rial
$
Rial
Rial
Stagflation
Oil Revenue Ministry of
Petroleum
Finalizes and Signs the
Contract
Oil and Gas Are
Exported
16
Consequence of Mismanagement of Iran's Economy: Stagflation
Resolving
Inflationary
Pressure
Contractionary
Fiscal and
Monetary Policies
Increases
Unemployment
Resolving
Unemployment Expansionary Fiscal
and Monetary
Policies
Increases
Inflation
Solution One
Solution Two
The worst of all possible economic worlds: A stagnant or slow
growth economy coupled with increasing inflationary pressures.
Stagflation = Inflation + Recession
17
Consequence of Mismanagement of Iran's Economy: Stagflation
Does Iran economy have:
Chronic inflation: Annual rates of 10% to 35% for 2-3 years.
Hyperinflation: An inflation rate of 50% per month.
Recession: Decline in two or more consecutive quarters decline
Depression: A recession that lasts longer and has a larger decline in business
activity.
Stagflation: Inflation with recession
Growth
Hyperinflation
Inflation
Depression Recession
Pri
ces
Stagflation
Explosive Volume of Debt During 1384-1391
Government entities debt to BM
Government entities debt to banks
Government and state-run entities
debt to banks
Government debt to BM
Government debt to banks
2.2
7.7
31
10.1
3.4
23.5
2.3
95
18
51
1384 1391 Growth
10x
(70%)
3X
80%
15X
Government and State-Run Debt to Financial System
(thousand billion toman)
19
Growth of Overdue Loans
Overdue Loans (billion toman)
1383 1391 Growth Rate
4,500 80,000 18x
China: 6.8%
Malaysia: 6.8%
Nigeria: 8.5%
India: 2.8%
Kuwait: 3.5%
Lebanon: 10.4%
Pakistan: 8.7%
Percentage of
Delinquent Loans 10% 22% 2.2x
Iran Other Countries
Iranian banks are capitalized at $20B, while the overdue loans are $34B.
No mechanism to follow up with the borrowers. Instead loans were used for:
trade, FX speculation, and capital outflows.
In many cases, the recipient of a loan was just an intermediary for passing the
fund to a third party.
Sources: General Inspection Office,, and Donyaye
Eqhtesad September 9, 2013 20
Current Economic and Government Spending Is Unsustainable
21
Public Sector Private Sector
Budget for fiscal 2013 assumes an oil price of $140/barrel.
Budget deficit for 2013 is estimated to be $35 billions.
The new government is unwilling to bear the political burden of cutting spending or
raise revenue through taxes.
Therefore, they have to continue to borrow more from local banks.
Eventually, they have to make fiscal cuts, which, in turn, could exacerbate the current
economic recession.
See M. Dubowitz and R. Ziemba ―When Will Iran Run Out of Money?
Roubini Global Economics October 2013
Borrow, Spend, and Keep the Currency Artificially Low
Total oil revenue
during 2005 – 2011
Total imports
during 2005-2011
During
Ahmadinejad’s
Administration
During 16 Years of
Rafsanjani and Khatami
Administration Combined
$560B $433B
$330 $110B
2005 2011
IR113 trillion
IR403 trillion
4x
Total Government Debt to the
Domestic Banks
Financial Repression In Iran
Explicit Or Indirect Caps / Ceilings On Interest Rates
Government regulation
Ceilings on bank lending rates
Quantitative controls on credit allocation
Creation and Maintenance of a Captive, Domestic Investor Base
Requiring financial institutions to hold substantial government debt.
High reserve requirements.
Capital account restrictions and exchange controls to force a 'home bias'.
Extensive Management Over Banks and Other Financial Institutions
Source: The Liquidation of Government Debt, Carmen Reinhart and M. Belen Sbrancia.
Also see Morgan Stanley Research on Sovereign Subjects August 25th, 2010
23
Financial Repression Always Leads To Inflation
Why Financial Repression Leads to Inflation
To Get Rid of Debt Burden
Grow Restructure Default Inflate
Growth is unlikely; restructure is impractical, and default is politically
unattractive.
Unable to raise taxes due to administrative inefficiencies or political constraints.
Therefore, inflation is the remaining option.
Increase liquidity by a factor of 7x during 1384-1392
24
Injecting Liquidity Does Not Lead to Economic Growth
1384
Growth
1392
67 Liq
uid
ity
(t
rill
ion)
450 6.7x
25
M x V = P x Q
M: the money supply
V: the velocity of money
P: the price level
Q: the real output of the economy
Iran’s Faultlines
Iran’s Banking System
Has the lowest score in MENA.
Its capital adequacy are dropping.
Banks are lending mainly to the government.
Inability to raise capital from local banks coupled with increased rigidity suggests
that the non-oil economy will find it difficult to adapt, amplifying the effect of
economic sanctions.
Smaller, unconnected private corporations, which stand out as vulnerable to cheap
imports cannot access any capital.
High levels of corruption and weak rule of law impair banks’ ability to collect
non-performing assets from politically connected groups.
26
23,2013 M. Dubowitz and R. Niemba ―When Will Iran Run Out of Money?
Roubini Global Economics October 2013.
Iran’s Faultlines – cont.
Human Capital
Educated human capital has migrated abroad.
Although Iran has relatively good education, including significant tertiary
education, the human resource capacity, which businesses can use has
weakened.
Iran has particularly low perceived deprivation (the reality-expectations gap
concerning the quality of social services) which tends to be a precursor of
political shocks or a divided society.
Iran has one of the least energy-efficient economies, worse even than many of
its oil-exporting peers.
27
23,2013 M. Dubowitz and R. Niemba ―When Will Iran Run Out of Money?
Roubini Global Economics October 2013.
Business Environment in Iran is Abysmal
The minimum institutional requirements for creating a conducive environment
to do business are:
A stable (domestic and foreign) political environment.
Public's respect and trust for the rule of law.
Access to capital.
The impartiality of the judicial system.
A total transparency on the part of government and its agencies.
28
Untangling, Understanding, and Prioritizing Iran's Economic Issues
The new administration has many issues to resolve.
The tendency is to tackle all at the same time, which is the wrong strategy.
What are the most urgent issues?
What are the most important issues?
Pick 2 issues to tackle immediately.
Im
port
an
ce
Low High Urgency
Low
High
Important
Critical
Interruption Distraction Budget Deficit
Inflation
And
Improving Business
Conditions
Unemployment
Mehr Afrin
Program
Iran's economy is at a critical point.
29
Coordination and Independency
Ministry Economy and Finance
(Fiscal Policy)
Bank Markazi
(Monetary Policy)
Management and Planning
Organization
(Government Budget)
Independence
and
Coordination
These three offices should coordinate budget, fiscal policy, and monetary policy.
But, the independence of decision making process for these three organizations should be observed.
Ultimately, it must eliminate economic insecurity and uncertainty if it wants to create a stable
economic environment for businesses to flourish.
Wise regulation is how human societies turn a useless jungle into a prosperous garden.
Central Bank
31
From Gold and Precious Metals to Fiat Money
32
Fiat Money Private Issuers Precious Metals
In the U.S. between 1837 and 1866 (―Free Banking Era‖), almost anyone could
issue paper money.
States, municipalities, private banks, railroad and construction companies,
churches and individuals printed an estimated 8,000 different monies by 1860.
The result was crisis after crisis.
In 1913 the Fed was created - largely in response to a series of financial panics,
particularly a severe panic in 1907.
From Gold and Precious Metals to Fiat Money
Central banks have emerged over the past four centuries when countries
moved from a system of gold or silver backed currencies to private
issuers to fiat money.
Because of this transformation to fiat money countries gave their central
banks the responsibility for keeping inflation low and providing a money
supply that does not overshoot economic growth too much.
Throughout the past four centuries, political pressures have often led to
inflation as governments want to finance their activities with what appeared
to be a seemingly cheap alternative.
33
Central Bank Goals and Responsibilities
Responsibilities of Central Banks
Control the availability of money
and credit.
Be Lender of the Last Resort
(LOLR)
Supervise commercial banks
Manage the payments system
(settle inter-bank payments)
Primary Goals of Central Banks
Low and stable inflation
Stable growth with low unemployment
Stable financial markets
Exchange rate stability
Central banks have caused many financial disasters:
Inflation, Hyperinflation, Deflation, Depression, Currency
Crisis.
1900 2009 Total Number of CB 18 175
34
Monetary Policy
35
.
What Is Monetary Policy?
Monetary policy is the management of the flow of money and credit in an
economy, in order to preserve confidence in the value of money.
The best way to achieve monetary policy goals is to keep:
Inflation low, stable and predictable; and
Thereby giving the markets the confidence in the future value of their
money, so they can make sound economic and financial decisions.
In order to implement monetary policy, it is ideal to have an experienced,
respectable, and credible executive team at the head of a central bank.
36
Components of Monetary Policy
Stable and Low Inflation
High Employment and
Growth
Financial Market Stability
Inflation
Money Supply
Interest Rate
Exchange Rate
Open Market Operations
Discount Loans
Changes in Reserve
Requirements
Tools Targets
Goals
Goals
The distinction between the various types of monetary policy
regimes lies primarily with the set of tools and target variables that
are used by the monetary authority to achieve their goals.
37
The Transmission Mechanism of Monetary Policy
Central
Bank
Credit
Interest Rate
Exchange Rate
Asset Price
GNP
Inflation
Monetary
Policy Channels Output
Note: For a detailed discussion of various structural channels see F.S.
Mishkin, "The Channels of Monetary Transmission: Lessons for
Monetary Policy" 38
Monetary Policy Goals
Three key goals of modern monetary policy:
Price Stability: Low and stable inflation is supportive of real growth in the
long run.
Stable Real Economy: Often interpreted as high employment and high and
sustainable economic growth.
Financial Stability: This encompasses an efficient and smoothly running
payments system and the prevention of financial crises, involving:
Microprudential Policies: Regulation of individual entities.
Macroprudential Policies: Identifying system-wide vulnerabilities and
using panoramic view of the financial system to measure credit, market,
and liquidity risks.
Tiff Macklem "Mitigating systemic risk and the
role of central banks" June 2011. 39
.
Why Focus on Money and Inflation?
Based on a large body of reasoning and empirical evidence, the policies of the
most central banks are grounded in four essential propositions:
Central banks are unable to directly influence variables other than inflation
for any sustained period of time.
Inflation, in most cases, is a monetary phenomena.
Low and stable inflation rate is conducive for growth and employment.
High inflation is damaging to the economy and costly for firms and
individuals.
40
Basic Principle of Monetary Policy
The central bank influences interest rates by expanding or contracting the Base Money.
Then, the Multiplier Effect of fractional reserve banking amplifies the effects of these actions.
Assets Liabilities
Balance Sheet of a
Central Bank
Domestic assets
(usually government
bonds)
Foreign assets of
the central bank
Currency in use
(C)
Banks reserve at the
central bank
(R)
Base Money = C + R
OMO Base
Money
Money
Supply
Interest
Rates
41
Attributes of Monetary Policy Tools
An Effective Instrument is:
Easily observable in the market.
Controllable by the central bank.
Related to both the goals and to the tools of monetary policy.
Out of three tools, one instrument Open Market Operations (OMO) is
the most effective for implementing monetary goals.
OMOs are effective because they are:
Quick;
Immediate;
Completely control by the Central Bank;
Flexible; and
Easily reversible.
42
Lags and Impacts of Different Policy Tools
Lag
Short
Long
Impact
High Low
Reserve
Requirement
&
Quantitative
Easing
Directed
Credit
Open
Market
Operations
Discount
Window
43
.
What Economic Variables Can Monetary Policy Control?
Monetary policies can have a sustained influence only on the rate of
inflation.
Monetary policy does not have a systematic and sustained effect on
macroeconomic variables other than the inflation rate.
A monetary policy action that in the short run leads to a change in output
and employment, in the long run, ends up changing only the rate of
inflation.
It is natural for central banks to adopt the one thing that they can
reasonably expect to influence over the long run—the rate of inflation.
Ahmadinejad's administration did not take note of these well
established maxims. The result has been disastrous.
44
Monetary Policy Challenges in Emerging Countries
General lack of independence:
Reports to finance or economic ministers.
Political appointments.
Dependence on commodity exports. The job of the central bank is not to stabilize
commodity price. But the price fluctuations of commodity prices becomes a central
bank problem due to its impact on exchange rates.
Lack Of Developed Financial Markets
Means the interest rate channel of monetary policy transmission is less
effective.
Also means that there is limited feedback from the market about monetary
policy.
Consequently, there are longer lags in the impact of monetary policy in
emerging economies.
45
Central Bank Governance
46
Bank Markazi's Organization
Money and Credit Council (MCC)
Governor
Finance and Economy Minister
Two Ministers chosen by the Cabinet
The Head of the Chamber of Commerce the
General Prosecutor
Two MPs
Independence of BM depends on the function of
MCC and how its members are elected.
Executive
Management
Governor
&
MCC
Governor
Vice Governor
Three Vice
Presidents
The President of Iran proposes the governor of CBI,
who must be verified by the General Assembly and
appointed by presidential decree.
MCC is the highest banking policy-making body of Bank
Markazi, and yet, currently is not independent of the government.
47
Central Bank Governance
The governance structure of central banks and their relation with their
respective governments has evolved during past three decades.
This evolving relationship has had many dimensions:
Appointment and dismissal of the central bank governing board.
The voting power (if any) of the government on the board.
Budgetary control of the central bank operation.
Limitation on central bank lending to the government.
The key issue for a CB is "credibility".
See Carl Walsh "Central bank independence", prepared for the New
Palgrave Dictionary.
48
Credibility
How does a CB gain credibility?
49
When a central
bank is credible
It become
trustworthy
It can be relied
to meet its
commitment and
promises
CB become credible when markets and public trust them to maintain the purchasing power
of the money they issue.
In modern economy in which public cannot measure the value of money against an external
standard (like gold) - all money is fiat money.
That is, money’s value is stipulated by fiat, and the role of CB is to pledge to maintain this fiat
value. Therefore, money is only a promise.
Market participants continuously look to CB for signals that ensure the continuity of this
promise.
Credibility Is A Social Relationship As Much As An Economic Relationship
Credibility and The Pillars of Central Bank Governance
Central
Bank Governance
Authority
Transparency
Accountability
Independence
Bank Markazi's Governance Shows Deficiencies
In All Four Areas.
50
How To Enhance The Credibility of a Central Bank
The Pillars of Central Bank Governance: Interrelationship
Transparency is an important element of accountability.
Accountability depends on independency.
To be independent requires transparency.
Authority without accountability is meaningless.
Independence Transparency
Authority Accountability
51
The Pillars of Central Bank Governance: Independence
An effective and successful central bank:
Is independent of political pressure.
Its decisions are not reversible by the government.
Makes decisions by committee.
Openly states its goals and makes clear the trade-offs among them.
The idea of CB was
originally to be the
government's bank.
The idea of a separate,
largely apolitical,
institution gained
momentum in 1950s.
Politicians short term
preferences conflicted
with the CB's long term
goal of price stability.
Source: IMF research. Central Bank Autonomy, Accountability, and
Governance: Conceptual Framework prepared by Tonny Lybek
Studies show CB's independence reduces inflation.
52
The Pillars of Central Bank Governance: Independence
Goal Autonomy: Gives the central bank authority to define and prioritize
objectives (e.g. the Fed). Goal autonomy is the broadest degree of autonomy
and authority.
Target Autonomy: Target autonomy has one clearly defined primary objective
stipulated in the law. For example, the statute of ECB clearly states that the
primary objective is price stability with the target determined by the ECB.
Instrument Autonomy: Unencumbered power to implement monetary policy
with the aim of achieving externally established goals.
Limited Autonomy: Means that the central bank is effectively a government
agency (Iran).
IMF research. Central Bank Autonomy, Accountability, and Governance: Conceptual
Framework‖ by T. Lybek and D.E. DeRosa "Central Banking in Emerging Markets
nations". 53
Independence Measurement Index
The CWN index has four components, relating to, respectively,
Internal Workings Of The Central Bank
Procedures for selecting the head of the central bank.
The use of an explicit policy target.
Relations Between The Central Bank And The Executive Branch
The resolution of conflict between the central bank and the executive branch of
government,
Rules limiting lending to government.
Since 1980:
Developing Countries
The most significant increase in all four measures of independency since 1980.
Advanced Counties
Relative improvement on the second set of attributes. That is relation with the government.
They had already had high score of independency reflecting the internal procedures.
54 Cukierman, A., S. B. Webb, and B. Neyapti, 1992, ―Measuring the Independence of Central
Banks and Its Effect on Policy Outcomes,‖ The World Bank Economic Review
Central Bank Governance: Transparency
Transparency:
Is key to fostering public trust;
Reduces the uncertainty about the central bank's preferences; and
Helps private sector to plan and make decision.
Market should respond to information, not to speculation about what policymakers are doing. People
should know:
What a central bank is doing;
Why it is doing it; and
How it makes decisions.
To enhance transparency, central bank's communications should cover both current and "forward-
looking" opinions:
Annual or semi-annual report to parliamentary committees;
Media reporting;
Website communication; and
Other written materials such as speeches or policy papers.
Lack of transparency leads to corruption.
55
Central Bank Governance: Accountability
Accountability requires two important yardsticks:
Objective: Quantified intermediate goals like inflation target.
Projections: How accurate is the CB's projection for monetary policy?
Objectives:
Single objective: Provides a more precise basis for delegating authority and
accountability to CB and holding it accountable.
Multiple objectives: Can dilute accountability, and complicate the
coordination of economic policies with the government.
Accountability also requires:
Who makes the decisions about the ultimate objectives of monetary
policy?
Who bears final responsibility for monetary policy?
How transparent is monetary policy?
See: J. de Haan*, F. Amtenbrink, and S. Eijffinger "Accountability of
Central Banks: Aspects and Quantification".
56
Recommendations For Bank Markazi's
Governance
57
The Money and Credit Council (MCC)
Current Formation
Permanent members include:
The CBI Governor;
The Finance and Economy
Minister;
Two Ministers chosen by
the Cabinet;
The Head of the Chamber of
Commerce;
The General Prosecutor; and
Two MPs.
MCC members are not only not independent but most are
also unqualified.
MCC's Crucial Role
Each year, after approval of the
government's annual budget BM
presents a detailed monetary and
credit policy to the MCC for
approval.
Afterward, major elements of
these policies are incorporated in
five-year economic development
plan.
MCC is effectively the legislative
branch.
58
Governance Principles For Bank Markazi: Independence
Bank Markazi's commitment to price stability will be deemed more credible
when proper institutional reforms are adopted.
Credibility of Bank Markazi is the key.
The institutional reforms required to enhance credibility include the procedure
for selecting the governor of BM and its MCC members.
Three criteria for selecting the key members are required:
Integrity
Impartiality
Competence
Continuity
59
Governance Principles For Bank Markazi: Independence– cont.
MCC Members Tenure
The security of tenure is the key for the credibility.
To shield it from undue short-term political influence, MCC members should be
elected for at least 5 years.
The Governor of BM should be elected every 5 years.
This length exceeds the electoral cycle, and therefore helps to depoliticize the
selection process.
Members should be recommend by the President but ratified by the Majlis.
60
BIS Study In 2007
75% of the governors had fixed terms of office that lasted either five or six years.
In more than two thirds of central banks surveyed by the BIS, two or more political bodies were
involved in proposing and appointing the candidates.
About 80% of countries have revised their central bank laws since early 1990s.
Governance Principles For Bank Markazi: Independence – cont.
BM should be prohibited to lend to the government, its agencies or enterprises, unless approved by Majlis. Either way, only a minimal amount should be allowed.
The law should grant BM independence to pursue its monetary and exchange-rate policy, implying full instrument independence.
The Goal of monetary policy has to be ratified by Majlis. BM's role is only advisory in this matter. Primary goal should be price stability.
BM should ultimately be accountable to the Majlis and judiciary branch.
The government should reorganize the authority and independence of Council on Money and Credit (MCC).
61
Governance Principles For Bank Markazi: Independence – cont.
Under exceptional circumstances, the government may overrule the
inflation target of BM by informing it in writing and copying both judicial
and legislative branches.
It should also indicate when and under what condition this override will be
lifted.
Conflict Resolution
62
Proposal For BM's Governance Structure: Accountability
Bi-annual appearance of the Governor at the Majlis in order to describe the
economic and monetary issues, including:
Analysis of economic conditions;
Forecasts of key policy variables such as inflation and output;
Reasons for their policy decisions; and
Discussion of any policy contingencies under their consideration.
The reports should also be published in the domestic newspapers and
magazines.
63
Governance Principles For Bank Markazi: Authority
The financial standing of BM in terms of its budget and its balance sheet
should be strong enough in order to send the signal that it has sufficient
capital to carry its monetary policy goals.
Therefore, BM should retain its profits and losses so that over time it can
build up its financial strength.
Financial autonomy is a must for operational effectiveness.
The Government and Majlis can appoint an independent supervisory
board to approve BM's operational budget.
64
Governance Principles For Bank Markazi: Transparency
Political
Transparency Operational
Transparency
Policy
Transparency
Procedural
Transparency
Economic
Transparency
Is BM's mandate clearly
communicated to public
at large?
Does the release of
economic information
by BM enable people to
make their own
assessment?
See Central Bank Independence and Transparency by
Christopher Crowe and Ellen E. Meade
Does BM provide
written information
on how it arrives at
its policy decisions?
Does the public have
immediate access to
detailed account of the
thinking underlying
the decisions made in
the policy meeting?
Does BM asses the
accuracy of its past
forecasts and
accounting for past
errors in policy?
Attributes For BK's
Transparency
65
Inflation And Monetary
Policy In Iran
66
Two Decades of Improvements in Developing Countries
Have brought down inflation rate to single digit.
Have established more independent monetary policy regime.
Broadened their financial institutions.
Created more advanced and efficient capital markets.
Have increased the importance of the role of the central banks.
Enacted transparency laws, accountability, and responsibility.
Have opened up their domestic markets to trade and finance.
For an in-depth discussion of this development see M. Mohanty and P. Turner ,
"Monetary Policy Transmission in Emerging Market Economies: What is New?"
…and yet Iran has not achieved any of these major improvements.
67
What is the Inflation Rate in Iran?
Steve Hanke ―On Iran’s Inflation Bogey‖, Cato Institute June 13, 2013. Djavad
Salehi Esfahani ―Is Iranian Hyperinflation A Mirage‖ Al Monitor January
23,2013 M. Dubowitz and R. Ziemba ―When Will Iran Run Out of Money?
Roubini Global Economics October 2013.
Low inflation: from 1-2% to 5% p.a.
Moderate inflation: 5%- 10% p.a.
High inflation: 10%-50% p.a.
Extremely high inflation: could range anywhere between 50% and 100% p.a.
Hyperinflation: Triple digits p.a.
68
Chronic Inflation In Iran
Inflation in Iran has:
Eroded savings;
Inhibited growth;
Discouraged investment in domestic production;
Encouraged capital flight;
Increased demand for unproductive real estate investments;
Pushed up precious metals;
Made economic planning by both private sector and public enterprises
impossible;
Provoked social unrest; and
Imposed a form of regressive taxation that hits poor hardest.
To reduce inflation significantly, it is imperative that the
government in Iran adopts conservative and sustainable
fiscal and monetary policies. 69
Types of Inflation
Types of Inflation
Demand-Pull
Inflation Cost-Push
Inflation
Structural
Inflation
Expectational
Inflation
Iran's inflation is combination of all of these, with
Structural Inflation the most significant contributor.
70
Iran's Misguided Policies – cont.
Iran's Inflation Is Due All Four Factors:
Excess liquidity increased demand-pull component of the inflation.
Sanctions caused supply-push inflation.
Chronic inflation and lack confidence in future monetary and fiscal
policies has created inflationary expectations.
Consecutive and increasing fiscal deficit and government's insistence
on excessive monetary policy has generated structural inflation.
71
Denials, Denials, Denials….
Exchange
Rate Inflation
Ahmadinejad: The currency upheaval is due to a conspiracy among
Private exchange dealers (Sarafi);
Opposition politicians; and
Hostile press.
The Central Bank Governor: It is a reflection of a mob mentality,
and the product of a "defective exchange market" where "hoarders,
smugglers and soulless speculators" are trying to create "a false
demand" for dollars as a "venue for investment."
Source: J. Amuzegar, Middle East Economic Survey
What was the government response to deteriorating inflation and weakening
foreign exchange rate? Denials, Denials, Denials
72
Monetary Policy Trends In Iran
Direct ceiling as the main direct policy
has been replaced by 90% of central
banks during last two decades.
It involve the use of the statutory reserve
requirements and direct lending.
73
Monetary
Policy Tools
Direct
Instruments Indirect or Market
Instruments
Market – oriented instruments
have become the policy of choice
compared to direct instruments
oriented policies are: discount
rates, open market operation
(most popular), and foreign
exchange swaps.
Iran is one of the few countries that uses direct instrument by allocating credit in terms of:
Amount of credit (quantity).
Deposit rate (price).
Expected rate of return.
One of the few countries that has seen its inflation continuously edging upward.
Monetary Policy Instruments in Iran
74
Assets Liabilities
Deposits Loans Government Government
Direct Instruments
Banking profit rates: Bank Markazi sets the profit (―provisional) and expected rate of return on (minimum
and maximum) banking facilities .
Credit ceiling: Bank Markazi intervenes in banking affairs through directing loans to various sectors.
Indirect Instruments
Reserve Requirement Ratio: Bank Markazi is authorized to set RRR within 10% to 30% range.
CBI Participation Papers: Securities (Oraqh -e- Mosharekat) is issued with the approval of MCC, the
government, and the Parliament.
Open Deposit Account (ODA). The main objective of ODA is to control liquidity through absorption of
banks’ excess resources.
Primary Instruments of Monetary Policy in Emerging Economies
Latin America
Argentina
Chile
Venezuela
Asia
China
Indonesia
Korea
Malaysia
Philippines
Central Europe
Czech Republic
Poland
Middle East
Israel
Saudi Arabia
Turkey
Developed
United States
Japan
Euro Area
U.K.
Credit
ceilings
Reserve
requirement Open market
operation
Discount
rates FX market
operations
Moral
suasion
Primary Instruments of Monetary Policy
Yes Yes Yes
Yes
Yes
Yes
Yes
Yes Yes Yes
Yes Yes Yes
Yes
Yes Yes
Yes Yes
Yes
Yes Yes
Yes Yes
Yes Yes
Yes
Yes
Yes
Yes Yes Yes Yes Yes Yes Yes Yes Yes
Source: M. Mohanty and P. Turner , ―Monetary Policy Transmission in
Emerging Market Economies: What is New?‖
None of the following countries employ direct instrument (credit ceiling) which is
Bank Markazi’s main policy tool.
Obstacles in Formulating Effective Monetary Policy in Iran
Central Bank
A dysfunctional Bank Markazi
Government dominance of
monetary policy.
Economy
Tow-tier economy with
considerable activity in grey
markets.
Out-of-control deficit.
Driven by oil revenue.
Pervasive corruption.
A country that 85% of its economic activities is controlled by the government
will not respond to market-driven monetary policies.
76
Financial System
Illiquid interbank money markets.
Rudimentary capital markets, and
inadequate disclosure and
accounting standards.
No representation of the term
structure of interest rates.
Limited monetization of the
economy.
Difficulties in complying with
Sharia law.
Iran's Ranking in Global Competitive Index
The report by World Economic Forum in September 2013 showed Iran's
standing among 148 countries as follows:
Macroeconomic environment
Financial market development
Business sophistication
Labor market efficiency
Institutions
Global competitive index
100
130
104
145
83
82
Rank
77
Less than average in all indicators.
Iran Ranks Near the Bottom of its MENA Peer Group
78
Monetary policy
Fiscal Deficit
Total indebtedness
Banking sector
Government effectiveness
Rule of law
Political risk
Business environment
Algeria Egypt Iran Iraq Jordan Libya S.A. Turkey
2.4 0.8 0.0 4.7 5.3 10.0 7.8 2.7
7.7 0.0 3.1 10.0 0.5 10.0 10.0 6.7
9.8 6.1 9.8 8.1 3.6 10.0 9.5 8.6
6.8 6.8 3.4 6.1 8.3 6.0 7.1 5.9
2.5 4.3 2.0 0.2 6.2 1.2 5.7 5.8
2.7 3.0 2.1 0.9 5.1 0.7 3.7 5.7
4.7 5.0 3.6 3.7 5.3 3.3 4.4 3.9
2.8 4.3 3.2 1.9 5.4 3.1 6.4 4.7
5.8 5.6 5.1 5.0 5.5 6.1 6.6 5.8 Country Strength (Overall Score
Roubini Global Economic October 2013
Islamic Banking Liquidity Issue
Assets Liabilities
Short-term
deposits
(Overnight to
One-year)
Long-term
loans
(One-year to
five-year)
Maturity Transformation
Risk Transformation
Asset/liability management requires a highly rated overnight instrument with stable value.
Sukuk (Islamic bonds) have long maturities and are illiquid.
This lack of market liquidity will be a major constraint to the development of an integrated
Islamic financial system in Iran.
79 For the issues related to Islamic banking see H. Mansour Rahavard no.
Iran Does Not Have a Mature Capital Markets
T0 T1 T7 T30
Bank Loan
Certificates of Deposit
Commercial Paper
Medium Term
Funding
Long Term
Funding Indefinite
Short Term
Funding
Bank Loan
Medium term Notes Long Term Bonds
Fixed Rate Preferred
Equity
Preferred
Money Markets Capital Markets
Time
Rates
Yield Curve
Businesses need a diverse and
flexible funding instruments.
80
Bank Markazi's Achievements
Sources:Tradingeconomics.com of Central Bank of Iran
Objectives
Maintaining the value of national currency
Keeping inflation low
Maintaining the equilibrium in the balance of payment
Facilitating trade-related financial transactions
Improving the economic growth potential of the country
No
No
No
No
No
No
Results
Exchange Rate
Source: See CBI.IR
Inflation Rate
81
What Are the Causes of Chronic
Inflation In Iran
82
Iran's Misguided Policies
Loans for
quick-return
projects
Subsidized
residential
loans
Targeted
subsidies
Chronic Inflation
83
Targeted Subsidies Program
Sources of Funding
Theoretically
From raising
prices of oil
products and
other goods
and services 100%
Source: August 25th , 2013 BBC Persian.
$2.3 billion/month
30%
Subsidy
Programs
Government
Industry
50%
20%
Allocation of Funds
Theoretically
General budget for 1391 shows:
66 billion toman was distributed.
Only 25 billion toman (38%) of it was financed from raising
prices of oil products and other good and services.
The remaining came from government debt.
84
Implementation of Subsidy Program
Government Sources:
General budget: 22%
Oil revenue: 11%
Bank Markazi: 17%
30%
Allocation of Funds
Theoretically
Subsidy
Programs
Government
Industry
50%
20%
Subsidy
Programs
Allocation of Funds
Reality
Various
Government
Sources
100%
50%
Sharghdaily various edition during August 2013.
Underestimated
the cost by 3x
85
The Results of the Subsidy Program
Promoting standards of living
Helping domestic production
Distributing the national wealth fairly and equally
Minimizing income disparities
Raising energy prices to international market level
Increasing efficiency and preventing wasteful consumption
Reducing fuel smuggling
Allocating more energy resources to boost production
Encouraging demand for domestically produced commodities
Enhancing country's oil and gas export capacity
Degree of Success Government Reform Objectives
None Somewhat High
Most statistics in this section is from IISD, "Recent Developments in Iran's
Energy Reforms" October 2012. Also, see Donyae-e-Eqtesad September 16,
2013 by . I. Noorbakhash and R. Hemati
Source: The objectives were taken from the Government sites.
86
Bad Idea and Bad Execution
Subsidy program encourages the policy of "handouts".
Consumption versus investment philosophy.
So far, $33 billion has been spent without any contribution to
the real economy.
Instead, this amount should have been invested in various
educational programs which would have had long lasting
impact on Iran's productivity.
87
Inflationary Pressure of Quick-Return Projects
Government Commercial
Banks
Tells Recipients of
Quick-Return
Project
500,000 Billion
Rials
$21-$42 Billion
$40 – $60B
Inflationary Pressure
After the Effect of
Money Multiplier
Political decisions not viability of the project.
Only 12% of these projects were completed.
Out of these only 50% were profitable enough to pay back the loans plus profits.
Therefore, only 6% of so-called "quick-return projects" were "successful."
Meantime established companies could hardly get loan facilities because banks had been
loaned out.
Bank Markazi
Rials Borrow
From a Central bank to a Central Planner
88
Inflation Targeting
("IT")
89
Evolution of Monetary Goals to Inflation Targeting
Foreign
Exchange
Targets
Monetary
Aggregate
Targets
Inflation
Target
Price Stability
Financial Stability
Growth
1970s 1980s 1990s Since 2008
High rates of inflation in
the 1970s and 1980s
Microprudential
Microprudential
&
Macroprudential
Anti-inflation
commitment
Low inflation
Multi goals
Note: Fixed exchange rate regimes were dropped both
during 1970s and 1990s. 90
Inflating Targeting (IT) - cont.
Current
Inflation
Target
Inflation
Target could be:
Single number
Range
Midpoint within a
band
Time
Rate
Monetary
Policy
A successful IT should achieve:
Low inflation
Low inflation volatility
Anchor inflation expectation
The main transmission channel for IT is interest rate.
Therefore, deepening financial sector is required if IT is to be effective. 91
Inflating Targeting (IT) – cont.
7% - 9% 7% ± 1% 8%
Point Point +
Tolerance
Range
Example
92
More than 90% of countries have managed to reduce their inflation to single
digits during last two decades by embracing IT regime.
An IT is based on sound monetary theory which says:
A move away from monetary policy as tool of short-term demand
management, or fine tuning, to a focus on the medium-term goal of price
stability.
There has been an increasing recognition of the benefits of low and stable
inflation.
A permanently low and stable inflation helps growth and employment
Inflation targeting is an effective way of anchoring inflation expectation.
See IMF World Economic Outlook, Summer 2005
Inflation Targeting Is Based On Sound Monetary Theory
93
Effective IT has to be accompanied with the appropriate structural
reforms of monetary and fiscal sector. The main ones are:
Strengthening the institutional structure of policymaking by providing
statutory independence to the central bank.
Improving the quality of macroeconomic data.
Establishing a capable technical team within the central bank in order
to produce accurate data as well as building robust models.
Strengthening and developing of financial sector for transmitting
monetary policy through interest rate channel.
IMF World Economic Outlook, Summer 2005
Institutional Requirements For Inflation Targeting
94
A Sample of Inflation Targets
Brazil
Chile
Czech Republic
Indonesia
Mexico
Philippines
Poland
Thailand
Turkey
G and CB
CB
CB
G and CB
CB
G and CB
CB
G and CB
G and CB
4.5% ± 2%
3.0% ± 1%
2.0% ± 1%
4.5% ± 1%
3.0% ± 1%
4.0% ± 1%
2.5% ± 1%
3.0% ± 1.5%
5.0% ± 2%
Yearly target
Around two years
12 – 18months
Medium term
Medium term
Medium term
Medium term
Eight quarters
Three years
G = Government
CB = Central bank Source: Recommendations for Bank Markazi is
based on (among other sources) the findings of Gil
Hammond "Inflation Targeting 2012", Bank of
England.
Name Target Set By Target Target Horizon
95
Turkey
Central bank was legally obliged to finance budget deficits, the inflation rate averaged
over 50% and in 1994 it exceeded 100%.
In Turkey, the central bank’s governance was fundamentally changed from being
subordinate to the Finance Ministry to being independent.
This reform that gave independence to the central bank in 2001, caused inflation to drop
sharply, and since 2005 it has averaged less than 10%.
More importantly, there has been no demonstrable inflation-unemployment trade-off, and
Turkey has been one of the faster growing countries in the world.
From a Central Planner to a Central Bank
Using the central bank to allocate credit has been most common in low income countries
lacking a developed monetary policy transmission mechanism.
Direct allocation of credit has often been associated with crony capitalism and corruption
as loans have gone to sectors with political clout rather than those with high productivity.
A recent example is Egypt under Mubarak’s rule.
Another example is Argentina. The Central Bank of Argentina had significant influence
on credit allocation decisions in the past, causing (among other factors) to 1999-2002
default.
A Sample of Inflation Targets – cont.
Implementing Inflation Targeting In Iran – cont.
Iran's current monetary policy is not conducive to an IT regime because of:
Ineffective monetary policy tools.
Fiscal dominance.
Unsuitable governance structure of Bank Markazi. MCC members are:
Not independent;
Do not have deep experience and knowledge in monetary policy; and
Are not tenured.
Compliance with Sharia Law.
Generally, a country which has had chronic (3-5 years) inflation in the range of
20%-25% is considered incapable of using monetary policy to bring about a
lasting and low inflation.
97
Requirements For Implementing Inflation Targeting
Assuming these shortcomings of Bank Markazi is rectified, then here are
essential steps to implement IT:
Announce explicit quantitative medium-term inflation target.
State unambiguous institutional commitment that price stability is the primary goal of monetary policy, which takes precedence over all other objectives.
State the goals of the bank in the following order: price stability, financial stability, and growth.
Develop a methodology or model for producing inflationary forecast.
Increase transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of Bank Markazi.
Accept accountability for attaining its inflation targets.
98
Inflation Targeting should be the sole responsibility of MCC.
Majlis's concurrence may be required but the government should not
have any say in this matter.
The Government could have an observer seat at MCC.
The number of MCC should be 5 – 7 people.
Members of MCC should have:
Highest integrity;
Independent mind; and
Substantial experience in monetary and economic issues.
The Right Structure of MCC For Inflation Targeting
99
Iran’s Exchange Rate and Inflation Targeting
Protracted
Budget
Deficits
Liquidity
Expansion Inflation Exchange
Rate
Average inflation rate
during 2005-2011
Iran Iran’s main trading partners
20% 3%-5%
Devaluation
According to PPP
Actual (IR9000 to
IR10,500)
80%
16%
Source: J. Amuzegar, and Bank Markazi
“In December 2010, Mr.
Ahmadinejad asked the head
of the CBI to come up with a
new and realistic exchange
rate in view of Iran's "ample
foreign exchange reserves" -
an order which some of his
aides at the time interpreted to
mean revaluing the rial
towards $1=IR5,000!”
Appropriate Exchange Rate Regime for Inflation Targeting in Iran
Free float
Managed float
Floating Fixed Intermediate
Currency board
Dollarization
Monetary union
Target zone/band
Basket peg
Crawling peg
Adjustable peg
Iran Should Employ A Managed
Floating Regime
See Ola Celausn "Exchange Rate Considerations in an Oil Country:
The Case of Islamic Republic of Iran. 101
A Framework For Analyzing Iran’s
Financial Health
102
A Framework For Analyzing Iran's Financial Health – cont.
Government's equity
Social Liabilities (NPV of future
expenditures such as
Maskan-e- Mehr, targeted
subsidies, public pension
funds, etc.)
Power to tax (NPV of future tax
revenues)
Gross Debt
Real Assets (Oil, and other minerals,
and other assets)
Other financial assets (loans, cash, etc.)
Equity holdings (e.g. stakes in banks)
Financial Assets
And Liabilities
(Future Flows)
Financial Assets
And Liabilities
(Outstanding)
Assets Liabilities
Government's equity is the same as net worth and,
therefore, a measure of solvency.
Morgan Stanley research on sovereign subjects by
Arnauld Mares, August 25th, 2010. 103
Who Pays For the Government Insolvency?
Who Pays For the Government Insolvency?
Most of its citizens:
Taxpayers – tax burdens increase.
Public Services – lower government expenditure,
result in less services and scaled-down
government programs.
Bondholders
Outright default
Repression
Negative real rates
Currency devaluation via inflation
Forcing domestic institutions to buy
government debt.
People's equity is the same as net worth and,
therefore, a measure of solvency.
104
Is There a Hope?
105
Right Overture
106
Political
Institutional Reform
Monetary Policy
Reform
On October 10. 2013, the new head of Bank Markazi said:
―The central bank’s main priority is to reduce inflation and money supply, even as the economy
is struggling with a recession.
We are now facing a stagflation. Expansionary monetary and fiscal policies will not help the
growth.
The government has agreed to separate monetary and fiscal policies. That will allow the central
bank to focus on ―controlling liquidity and bringing down inflation.‖
Replace Populism with Rationalism
Populist policies have no place in rational economic policymaking. Every case in developing countries has shown that empty (or ―full‖ of cash) populist policies not only fail to deliver on their promises but bring hardship to people that takes years to correct.
Policymakers must be guided by the accepted and proven laws of economics which have enhanced the lives of billions of people over the past four centuries.
Most importantly, let only rationalism based on factual confirmation guide policymaking.
Create an economy that rewards entrepreneurs and businesses for taking risks and producing the successes that will, in aggregate, allow Iran to take its place in the global marketplace commensurate with its history, its culture, and the education, talent and creativity of its people.
107
Does Iran Have the ―Instruments‖ to be a Successful Economy?
Iran has all of the ―instruments‖ of a
successful economy:
A young and highly educated
population.
Vast and diversified natural
resources.
A unique geographical position.
To turn these into a cohesive,
dramatic success, Iran needs:
A Maestro as its conductor;
A superb team of players
working together in harmony;
A cohesive, dramatic ―score‖,
with the ―orchestra‖ playing in
tune.
108
Appendix A
109
Economic Models
Economic Models
Positive Economics
Describes prevailing economic interactions in order to aid our understanding of the
existing relationships.
Normative Economics
Suggests on ways to improve the efficiency and equity of the economy.
Different Policy Recommendations
Economists recommends policies for both micro and macro issues.
Their disagreements are due to:
About how the world works because they are employing different positive theory.
Or, because they have different values about how the world should be because they are
using different normative theory.
110
This confusion between positive and normative approach at
times prevents constructive dialogue for policymaking
decision.
Economic Models
111
Input Output
Input Output
𝑥 + 𝑎 𝑛 = 𝑛
𝑘𝑥𝑘𝑎𝑛−𝑘
𝑛
𝑘=0
Structured
Causal
Correlates
Reduced
Black Box
Economic Models: Structured Form
112
Money
Supply Output
IS – LM Equation
Quantity Theory of Money
Structured
Causal
Transmission Mechanism:
The change in the monetary base interest rates.
Interest rates variations investment spending.
Investment spending is a component of aggregate output.
Establish how variables affect each other by using data to construct a model (theory) which explains the mechanism through which the causality occurs.
Economic Models: Reduced Form
Reduced Form
An empirical relationship between two variables is established.
For example, the relationship between the growth of a monetary aggregate and the rate of inflation.
Limitations of Reduced Form
Correlation does not imply causation.
Difficult to figure out the timing of changes in economic variables.
Time
Variables (y)
Time
Variables (x)
Y = F (X)
This method mainly establishes a relation but it does not describe the specific path.
Institutions and the Role of Government in Economic Development
Countries differ in their economic success because of their institutions, the rules influencing
how the economy works, and the incentives that motivate its citizen.
In general, there are two types of institutions:
Inclusive
Extractive
Inclusive Economic
Institution
Encourages the
Citizens in Economic
Activities That Use
Their Talents and Skills
Secures and Preserves
Private Property
Enables Individuals
to Make the Choices
They Wish
Creates and Respects an
Unbiased System of Law
114
Economic Development
115
Human
Physical
Natural Resources
Financial
Capital Markets
Business and
Trade
Capital Markets and Institution
Economic
Development
Output
Economic, Political,
Social and Cultural
Developments
Relationship Among
Different Sources of
Capitals
Free and Regulated
Markets
+ =
Basic Input-Output Logic
Auto Industry
Tires Plastic Steel Glass
The IO model is centered on the idea of inter-industry transactions:
Industries use the products of other industries to produce their own products.
For example - automobile producers use steel, glass, rubber, and plastic products to produce
automobiles.
When you buy a car, you affect the demand for glass, plastic, steel, etc.
Input-Output analysis estimate these inter-industry transactions and use those figures to estimate the
economic impacts of any changes to the economy.
Lags and Input Output Model
Large tables of data that describe the interconnectedness of the industries, households,
and government entities in an economy.
It tracks the flow of money from one entity to the next.
It is used for predicting and forecasting the impacts of potential future performance of a
regional economy & changes in inter-industry transactions.
Input Output Model
Economic Sectors
Models For Relationship Between Financial and Real Sectors
Financial Sector Real Sector
Channels
Asset Price
Credit
Economic model for individual behavior (household and firms).
Economic model for a particular sector (real estate).
Economic model for transmission of government policies.
Economic models for financial and real sectors.
Does finance have a temporary (short-run) and/or a permanent (long-run) effect on output?
Does output (growth) have any impact on financial sector (reverse causality)?
Do the two channels of financial intermediation – banks and stock markets – play equally
significant roles in supporting economic activity?
Appendix B
119
Microprudential and Macroprudential
Policies
Microprudential Policy
Microprudential: Regulation at individual entities.
Microprudential policies are not enough when dealing with Systemic Risk.
Problems occur when all institutions engage in similar behavior:
Selling distressed assets
Tightening credit standards (credit crunch)
Holding onto cash.
Commercial Banks Investment Banks
Insurance Companies Mutual Funds
Macroprudential Policy
Crisis of 2008 showed Microprudential policies are not enough when
dealing with Systemic Risk.
Paradox of Aggregation: Healthiness at the individual level is not equal
stability at aggregate level.
Aggregate problem arises when the financial sector as a whole becomes
overexposed to the same risks:
Credit: Borrowers will not repay.
Market: Collateral values will decline.
Liquidity: Assets cannot easily be sold or debts refinanced.
For example, in 2008, most credits were increasingly tied to the value of
real estate collateral.
Macroprudential Policy – cont.
Macroprudential Policy
After the 2008 crisis, authorities in many countries have been exploring ways to
prevent systemic risk. This has forced them to have a holistic approach.
Central banks have a pivotal role to play in mitigating systemic risk by:
Identifying system-wide vulnerabilities and using their panoramic view of the
financial system to connect the dots.
Supporting financial stability by providing emergency liquidity assistance to
solvent, but illiquid institutions.
Protecting the global financial system from the failure of one institution by
promoting robust core financial infrastructure and overseeing systemically
important clearing and settlement systems.
Macroprudential policy does not replace micrproduential policy, it complements it.
Development in Monetary Policy Since 2007 Crisis
Price Stability Microprudential
Price Stability
Financial Stability
Growth
Before 2007
Crisis
After 2007
Crisis
Goals Regulation
Microprudential
&
Macroprudential
Tiff Macklem ―Mitigating systemic risk and the
role of central banks‖ June 2011.
Macroprudential Policy For Iran
Both monetary policy and macroprudential policies should be used for countercyclical
management:
Monetary policy: Price stability.
Macroprudential policies: Financial stability.
124
Stijn Claessens, Fabian Valencia ―The Interaction Between Monetary
And Macroprudential Policies‖.
Macroprudential
Policies
Monetary
Policies
Financial
Stability
Price
Stability
Appendix C
125
Monetary Policy
Monetary Policy Tools In Industrialized Countries
Federal Reserve Banks’ Monetary Policy Tools Discount Rate
The interest rate at which the Fed stands ready to make short-term loans to member banks and other depository institutions.
Reserve Requirements The amount of money banks must keep on reserve at the Fed. Reserve Requirements influence the ability of banks to create new loans
which affects the broader aggregates (M1,M2,M3).
Open Market Operations Buying and selling Treasury securities between the Fed and selected
financial institutions in the open market. By purchasing or selling US Treasuries, the Fed can alter the supply of
bank reserves. Most important tool. Directed by the FOMC.
Changes in RR and Discount Rate tend to be relatively infrequent (perhaps
once or twice a year on average for the discount rate, and perhaps once every three to ten years on average for the reserve requirement).
The Federal Reserve has at its disposal several
different types of Open Market Operations
(OMOs), though the most commonly used are
repos and securities purchases.
The Fed conducts OMO with primary dealers -
government securities dealers who have an
established trading relationship with the Fed.
While the target policy rate is the uncollateralized
lending rate between banks (fed funds), the Fed
operates in the collateralized lending market with
primary dealers (repo).
When the Fed sends and receives funds from the
dealer's account at its clearing bank, this action
adds or drains reserves to the banking system.,
thereby affecting short-term interest rates and by
extension other interest rates.
Lags and Uncertainty in Implementing Monetary Policy
Repo (Collateralized)
Primary Dealers
Account at Clearing Banks
Reserves of Banks at the Fed
Fed Fund Rate (Uncollateralized)
Other Short Term Interest Rates
Yield Curve Yield
Time
Lags and Uncertainty in Implementing Monetary Policy – cont.
Open Market Operation
Reserves
Fed fund rate Monetary base
Market interest rate
Asset price level
Money supply
Real rates Exchange rate
Relative price level Collaterals
Loan supply
Aggregate Demand
Narrow credit
channel
Broad credit
channel
Interest rate
channel
Wealth
channel
Monetarist
channel
Exchange rate
channel
The Transmission Mechanism of Monetary Policy
The transmission mechanism is characterized by long, variable
and uncertain time lags.
Market Rates
Asset Prices
Expectation/
confidence
Exchange
Rate
Official
Rate
Domestic
Demand
Net External
Demand
Total
Demand
Domestic
Inflationary
Pressure
Import
Prices Inflation
Iran uses only one of these transmission mechanism. Besides, due to it
underdeveloped financial system it cannot get meaningful feedback from
market conditions.
Copyright 2007 Jeffrey Frankel, unless
otherwise noted
M1 (most liquid): Consists of coins and
currency kept by the public, checkable
deposits, and travelers checks.
M2: Consists of M1 plus savings deposits,
and money market mutual funds
M3 (least liquid relatively): Consists of M2
plus negotiable certificates of deposit
• Liquidity is a measure of the ease with which
an asset can be converted into money without
significant loss of value.
• M1, M2, and M3 are progressively less liquid.
Liquidity Monetary Aggregates (Supply)
Monetary Aggregates
The Monetary Base in the U.S.
Injecting Liquidity Does Not Lead to Economic Growth
M x V = P x Q M: the money supply
V: the velocity of money
P: the price level
Q: the real output of the economy
Change (M) + Change (V) = Change (P) + Change (Q)
Change (M) + 0 = Change (P) + Change (Q)
Example:
10% + 0 = Change (P) + 4%
Inflation = 6%
V is determined by things other than
prices.
Q is determined by real economic
factors such as the availability and
productivity of labor and other
resources.
M P
Appendix D
132
Importance of Capital Market For
Monetary Policy
Flow of Funds Through Capital Markets
Financial
Intermediaries
Lender –Saver
Households
Firms
Government
Foreigners
Financial
Markets
Borrower-Spender
Households
Firms
Government
Foreigners Direct Finance
Funds Funds
Funds
Indirect Finance
The development of financial sectors follows a trend beginning with channeling savings and investments
through banks followed by the development of capital markets as savers search for higher returns and
firms seek cheaper capital.
Financial Markets
Capital Markets
Equities
Cash Derivatives
Over-the-Counter
Commodities
Exchanges
Fixed Incomes
Primary Exchange Primary Exchange
Fixed
Incomes
Equities Commodities
Money Markets
Financial Markets Instruments
135
Financial Markets Exchanges
A key division within the capital markets is between the primary markets and capital markets:
Primary Markets: New stock or bond issues are sold to investors, via underwriting.
Secondary Markets: Existing securities are sold and bought among investors or traders.
The existence of secondary markets increases the willingness of investors in primary markets.
Primary Secondary
Markets
Trading
Exchanges
Electronics
136
Why and What Kind of Regulations?
Entry Exit Maintenance
Regulation for entering
or registering in a
segment of capital
markets (e.g. equity)
Regulation relating to
on-going disclosure
requirements
Regulation for M&A,
restructuring, and
bankruptcy
Asymmetric information in financial markets means that investors may be subject to adverse
selection, which overtime could keep them away from financial markets.
Banking Industry
Stock Markets
OTC and Exchanges
Commodities
Insurance Industry
Asset Management