The Causation between Inflation and Currency Devaluation: The Case of Iran

Abstract

In this paper, we demonstrate that the Iranian economy has experienced rapid and variable inflation and sharp and frequent currency devaluation. In addition, we detect correlation patterns between inflation and exchange rate by way of Granger-causality testing. We also identify a significant shift in both inflation and exchange rate time-series in 1980, right after theocracy replaced monarchy. Taking this structural shift into consideration, we detect no causal correlation patterns in the pre-revolution era. However, with inflation accelerating and currency devaluating, we discover that inflation Granger-causes exchanged rate and exchange rate Granger-causes inflation in the postrevolution period. We discuss that the key to breaking these correlation patterns is to increase the supply of foreign exchange from oil and non-oil exports in order to restore and stabilize the foreign exchange rate. To achieve this end, Iran must fully renovate its politico-economic system in order to lower political risk and brighten business climate.