Evaluation of monetary policy in terms of exchange rate shock, MDSGE approach: The case of Iran

In an open economy, the exchange rate is an important factor in the design of monetary policy. The nominal exchange rate may serve as the underlying objective of monetary policy in the short to medium term in its capacity as an intermediate target. The real exchange rate is of concern to policymakers not least because of its importance in determining the competitiveness of domestic goods in global markets, but because of its role as the driving force behind the expenditure switching effect. Many of studies also show that the real exchange rate directly affects behavior on the production side of the economy.
This paper underscores the importance of the direct exchange rate channel in the transmission of monetary policy effects in an open economy forward looking model. In fact, we study the impact of exchange rate shock on macroeconomic variables such as inflation and output in the context of incomplete exchange rate pass-through, using a new Keynesian dynamic stochastic general equilibrium (DSGE) model with microeconomic foundations for a small open economy, adjusted for Iran. DSGE models as one of the major developments in macroeconomics in the past few decades are based on the adoption of the inter-temporal utility maximization paradigm.
In our model, we assume that there are two economies. On the one hand, there is the domestic economy, designated as a small and open economy, and on the other hand, there is a foreign economy, considered considerably bigger compared to the domestic one and relatively closed. These features influence their mutual relations and it holds that the domestic economy does not influence the development in the foreign economy. In this paper, we model relations for the development in the domestic economy, and the rest of the world, i.e. the foreign economy, enters the model exogenously. In our model, it is assumed that the Central Bank minimizes a loss function, taking into account the deviation of inflation from its target, output stabilization. In addition, incomplete exchange rate pass-through has been considered by the means of nominal import price rigidity and modelling of the path which exchange rate changes affect the economy.
 In line with our purpose, two kinds of policies based on discretion and commitment are introduced into the model. Period by period optimization and the treatment of expectations as being fixed characterize discretionary policymaking in the forward looking framework. The first characteristic implies that the policymaker sets policy anew every period. The other characteristic suggests that the policymaker treats the expectations of agents as constants when re-optimizing every period. But Commitment implies that the policymaker follows a rule systematically. In view of the fact that the policymaker cares about deviations of inflation from target and deviations of the real output gap from its target level, the policy rule focuses on the two target variables.
Bayesian methods have been applied in order to estimate structural parameters of the model. To do so, we have used Central Bank's data during 1369-1393. Then, the model is simulated under two policies of discretion and commitment and the effect of exchange rate shocks on key economic variables in these two situations is compared.
The results of the research indicate that the initial effect of exchange rate shock on all variables is roughly the same in both scenarios, but in discretion mode it takes more time to regain long-term balance. Our analysis also reveals that the output-inflation trade-off is more favorable under commitment than under discretion in part because of the existence of the direct exchange rate channel, and the stabilization bias under discretion is weaker in an open economy relative to a closed economy. These results confirm the importance of the exchange rate in the design and implement of monetary policy.