Inflation, budget deficit and discretionary monetary policy (Within the framework of Nash equilibrium and mixed strategic games)

اقتصاد پولی مالی

Article 5, Volume 31, Issue 27, January 2024

Document Type: پژوهشی

DOI: 10.22067/mfe.2024.86249.1375

Authors

Abdorasoul Sadeghi¹; Farkhondeh Jabalameli^{* 2}; Aliasghar Heidari Zefreh³

¹University of Tehran

²Department of Economics, University of Tehran, Tehran, Iran.

³Department of Economics, University of Isfahan, Isfahan, Iran.

Abstract

1- Introduction
Given the continuous budget deficit of government mainly coming from the lack of alternative financial resources for oil revenues, unstoppable upward trend of consumer price index, two-digit rates of unemployment, and as well as a non-independent Central Bank., money, Central Bank, and its monetary policies have always been a challenging issue in the Iranian economy. Hence, this study assesses the cause of preferring discretionary monetary policy to rule-based monetary policy in Iran’s inflationary environment of economy. In addition, we are supposed to find out whether or not the insistence on discretionary monetary policies can realize Iran’s government’s interests. Ultimately, according to the results, policy implications are presented to adopt monetary policies so that the government, Central Bank, and the private sector reach better outcomes.

2- Theoretical Framework
The question is whether policymakers can make a credible commitment to the private sector concerning the future monetary policy, so that they can set their price expectations based on monetary authority’s commitment? In response to this question, two types of discretionary and rule-based monetary policies have been formed. Discretionary monetary policy was first discussed by Simons due to considerable uncertainty arising from the 1930s deep economic recession (Glasner, 2017). In addition, the duality of discretionary monetary policy versus rule-based monetary policy was brought into discussion after the 1970s inflationary conditions (Dellas and Tavlas, 2022). In this regard, Simons considers predictability of monetary policy as a necessity for achieving stability and reducing uncertainty in an economy. Friedman also recommends rule-based policies to reduce uncertainty (Tryoshin, 2023).
More prominently, this duality has always been a subject of debate after the studies of Kydland and Prescott (1977) as well as Barro and Gordon (1983), which was brought into discussion the time inconsistency issue of discretionary monetary policy. The rule-based or discretionary monetary policies can influence the private sector's price expectations, which affect the central bank's objectives of maintaining price stability and surging economic growth. Therefore, as pointed out by Jia (2023), it finds much important for the private sector to suitably predict monetary policy objectives to set their price expectations. Hence, the Central Bank's rule-based or discretionary policies can impact the adjustment of the private sector’s price expectations in line with the declared policies. Some believe that the Central Bank cannot bind itself to a fixed monetary rule over an extended period of time. This is why new conditions may arise in the future, requiring the adoption of a new monetary policy to address those conditions. Hence, committing monetary authority to a fixed rule does not align with the realities (Snowdon and Howard, 2013), i.e., monetary policies are adjusted according to the economic conditions of that period of time (Laureys and Meeks, 2018; De Paoli and Paustian, 2017).

3-Methodology
According to the theoretical foundations, and Kydland and Prescott (1977) as well as Barro and Gordon (1983), under the framework of microeconomics bases, Nash equilibrium, and mixed strategic games, and as well as taking into account the two players of Central Bank and private sector, the cause of preferring discretionary monetary policy to rule-based monetary policy is examined. In this concern, given some realities related to the Iranian economy, we consider some assumptions. First, there is considerable amount of uncertainty. Therefore, both players, the private sector and Central Bank, have no enough confidence in the strategies chosen by the opponent. Second, the private sector places more importance on purchasing power of wages. Considering the passivity of real wages of labors and following their purchasing power to the inflation volatility, originating from the rigidity of nominal wages on labor contracts, more weight is given to the inflation rate compared to the unemployment rate by the private sector.

4- Results and Discussion
The results show that the Central Bank dependence and its being passive against the fiscal policies of government, an untrusting atmosphere between the Central Bank and privet sector, stagnation situation and a low economic growth, nominal wages rigidity on job contracts, nominal interest rates repression, and continuous budget deficit have made the Central Bank and government intended to improve the employment and budget deficit situations by an unpredicted inflation resulting from discretionary monetary policy. The earnings indicate that the private sector is in knowledge of this reality, and thus the Central Bank is no more able to take advantage of discretionary policies to deceive the private sector for achieving the objectives pointed out above. More explicitly, an equilibrium is formed in which both players distrust each other, and they take this distrust into their making decisions.

5- conclusion and policy implications
Not only the government, but also the private sector will not reach maximum earnings, and they both meet minimum earnings if the Central Bank keeps insisting on discretionary policies. Whereas they can both reach medium earnings, which is an optimal case, if the rule-based policies are followed. In this regard, the repression of nominal interest rates as well as the rigidity of nominal wages on job contracts have significantly motivated the Iranian government and Central bank to follow discretionary monetary policies. Because, all the government’s short-term benefits, resulting from discretionary policies, come from an unforeseen inflation that is not fully incorporated by the private sector’s price expectations. Iran’s government is aware of this economic reality, the rigidity of nominal wages on labor contracts, which can promote the employment growth by lowering the cost of real wages paid in the labor market. On the other hand, considering the repression of nominal interest rates that are not proportionally adjusted to the inflation rates, the real interest rates experience more decrease after a rise in inflation. Therefore, the cost of repaying the principal and interest rates of government’s issued bonds decreases, which improves the government's budget deficit. Thus, to change monetary policies from discretionary to rule-based policy, it is necessary to be moderated the factors motivating the government and Central Bank to pursue discretionary policies, including the rigidity of nominal wages on job contracts and the repression of nominal interest rates.

Keywords

Budget deficit; Discretionary policy; Inflation; Inflation expectations; Rule-based policy

References