Studying the Effect of Monetary Policies on Exchange Rate and its Effects on Total Welfare (Application of Recursive Dynamic Computable General Equilibrium)

Document Type : Original Article

Authors

• Elham Dehghani ¹
• Ali Raeispour Rajabali ²
• Seied Abdolmajed Jalaee Esfandabadi ³

¹ Ph.D. Student of International Economic Sciences, Islamic Azad University, Kerman branch, Kerman, Iran. [e-mail]

² Assistant Professor, Department of Economics, Faculty of Literature and Humanities, Islamic Azad University, Kerman Branch, Kerman, Iran.

³ Professor, Faculty of Economics, Shahid Bahonar University, Kerman, Iran.

https://doi.org/10.22067/mfe.2023.77575.1213

Abstract

 
1- INTRODUCTION
Welfare is one of the main men needs which economist and policy makers can tack appropriate planning and policies with true cognition from the effect of government policies on welfare. Generally, it is argued that the goal of monetary policies is making economic stability and remaining the stationary of prices. When money volume increases the level of expectation prices will increase and due to rising expectation inflation and reducing both producers and consumers welfare. Therefore, according to the negative effects of uncertainty conditions in economy on welfare of consumers and producers, assessing the effects of monetary policies on exchange rate in uncertainty conditions and its effect on welfare has undeniable importance for prevent from hazardous economic effects which carried out in this research. For this purpose, the effects of shocks due to monetary policies scenarios through increase in liquidity volume and decrease in required reserve rate (2%, 5% and 10%) on foreign exchange rate (Rial/US$) and total welfare was studied.
 
2- THEORETICAL FRAMEWORK
In the theoretical literature, two channels have been proposed for the effect of the exchange rate on the economy of a country; one is from a micro perspective (influence on economic agents, i.e. consumers, firms, investors, and the government) and the other is at the macro level. Many researchers have argued that households and firms are negatively affected by exchange rate fluctuations through direct and indirect channels. The direct influence of the exchange rate fluctuation is through the change in the price of imported consumer goods and as a result the change in the consumer price index, and its indirect effect is through the national monetary value and as a result the change in the price of intermediate goods and imported inputs, which leads to increase the cost of production. It is obvious that the uncertainty caused by exchange rate fluctuations has a negative effect on investment decisions, and the unreliability of economic conditions increases the severity of this effect. The direct influence channel is based on the assumption that people don’t desire with the fluctuation of the exchange rate, because it causes fluctuations in their consumption, employment and welfare. Its indirect effect is that firms try to cover future risks caused by exchange rate fluctuations by setting higher prices as a risk premium. Therefore, the price of goods and services increases. It is likely that the demand will be lower and the producers will hire fewer workers and as a result the economic welfare will decrease. This point of view is very common in the literature, and most economists do not consider this conclusion unreasonable that exchange rate fluctuations are costly for economic welfare.
 
3- METHODOLOGY
In order to meet the research goals the required data was gathered from Social Accounting Matrix (SAM) of Parliament Research Center of Iran in the year 2011 and input-output table of central bank of Iran (CBI) in the year 2016. On the other hand, many researches about the effects of monetary policies on economic variables have been carried out by using static computable general equilibrium and in most advanced case with dynamic computable general equilibrium models. But dynamic computable general equilibrium models divided in two categories: interim and recursive. The interim models are based on optimum growth theorem which assumed that economic agents have the ability of complete prediction while this doesn't correct many economic circumstances, especially in developing countries. Hence many economic experts believe that recursive models are more trustable. Therefore, in this research, in order to achieve the results from gathered data the recursive dynamic computable general equilibrium (RDCGE) model and impulse response functions (IRF) through making shocks on monetary police indexes include of: increase in liquidity volume (2%, 5% and 10%) and decrease in required reserve rate (2%, 5% and 10%) were applied. In addition, for data analyzing the Matlab software were applied.
 
4- RESULTS & DISCUSSION
Results indicated that shocks of increase in liquidity volume equal to 2%, 5% and 10%, maximally will increase the exchange rate equal to 0.97%, 1.98% and 3.08%, respectively. Also, shocks of decrease in legal reserve rate equal to 2%, 5% and 10%, maximally will increase the exchange rate equal to 0.84%, 0.90% and 1.14%, respectively. Because shocks of increase in liquidity volume and decrease in required reserve rate due to increase in money volume, causes to reduce in value of national money in comparison with foreign exchanges and therefore the Rial value of US$ will increase in domestic. In addition, results showed that shocks of increase in liquidity volume equal to 2%, 5% and 10%, maximally will decrease the total welfare equal to 1.19%, 2.47% and 3.53%, respectively. Also, shocks of decrease in required reserve rate equal to 2%, 5% and 10%, maximally will decrease the total welfare equal to 0.73%, 1.64% and 2.81%, respectively. Because shocks of increase in liquidity volume and decrease in required reserve rate due to increase in money volume, causes to reduce in value and power purchase of national money and consequently increase in inflation rate and decrease in total welfare.
 
5- CONCLUSIONS & SUGGESTIONS
It is concluded that the studies indexes of monetary policies (increase in liquidity volume and decrease in required reserve rate) will increase the foreign exchange rate (Rial/US$) and decrease the total welfare. Indeed, between studied shocks, shock of increase in liquidity volume has more effect on exchange rate and total welfare in comparison with shock of decrease in required reserve rate. Therefore in condition of uncertainty in exchange rate which economic agents transfer their assets to parallel markets especially foreign exchange market and cause to further increase in foreign exchange rate and consequently increase in inflation rate and decrease in total welfare, it is recommended that central bank take a restrictive monetary policy such as increase in bank interest rate because this policy while increase in investment cost, can almost prevent from speculative activities and transferring assets to exchange rate market and exacerbate the exchange rate fluctuations and finally decrease in total welfare.

Keywords

• Monetary Policies
• Exchange Rate
• Total Welfare
• Recursive Dynamic Computable General Equilibrium Model

Main Subjects

• Financial monetary economy

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