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